ZERODHA
Personal Finance Part 1
ZERODHA.COM/VARSITY
Table of Content s
1
Background and Orientation.
1
2
Personal Finance Math (Part 1)
10
3
Personal Finance Math (Part 2)
21
4
The retirement problem (Part 1)
33
5
The retirement problem (Part 2)
44
6
Introduction to Mutual Funds
58
7
Concept of fund and NAV
71
8
The mutual fund fact - sheet
81
9
The Equity Scheme (Part 1)
94
10
The Equity Scheme (Part 2)
108
11
The Debt funds (Part 1)
123
12
The Debt funds (Part 2)
138
13
The Debt funds (Part 3)
150
14
The Debt funds (Part 4)
166
15
Investing in Bonds
181
16
Index Funds
197
17
Arbitrage Funds
209
18
Measuring Mutual fund Returns
220
19
Rolling Returns
237
20
Mutual fund Expense Ratio, Direct, and Regular plans
247
21
Mutual Benchmarking
259
22
Mutual Fund Beta, SD, and Sharpe Ratio
273
23
Sortino and the Capture Ratios
286
24
How to analyse an Equity Mutual fund
295
25
How to analyze a debt mutual fund
314
26
The Mutual Fund Portfolio
330
27
Smart-beta funds
350
28
Asset Allocation, An Introduction
363
29
Exchange-traded funds (ETF)
376
30
Basics of Macro Economics
407
CHAPTER 1
Background and Orientation
1.1– What’s in the name?
I recently heard Joe Rogan’s podcast with Naval Ravikant. This is a 2-hour
conversation and I think this is one of the most thought-provoking and
stimulating conversations I’ve heard in a while. The topics discussed are quite
scattered and covers a diverse set of topics, but it has a great flow to it with
one thing leading to another. I’m awestruck with Naval’s multi-disciplinary
approach to many things in life including inner peace, creativity, capitalism,
and of course, wealth creation. The granular clarity he has on these topics is
quite impressive. I’d suggest you check out the podcast/YouTube video if you’ve
not already done that yet.
For obvious reasons, the wealth creation bit lingered on in my mind for a
while. I was thinking about what Naval said in this podcast and it resonated
with everything I have ever learned and experienced with money and my own
pursuit to generate wealth. I’m nowhere close to the ‘financial freedom’ state
he describes in the podcast, but at least I know that I’m not deviating much
from the track. While I continue this journey, I thought why not share some of
my experiences and learning with you all.
Hence this topic on ‘Personal Finance’.
When you think about personal finance, it oen circles around planning your
financials today, so that you have a better tomorrow. While some can do this
2
themselves (or so they believe), few consult a financial advisor to chart this
map for them. However, I’m not a big fan of approaching a financial advisor
to help you chart a plan for yourself and your family. You should be able to do
this yourself and your family.
Aer all, you know your family and their requirements best. You know what is
good for the family and what is not. You work hard for your family today and
dream of a secure future for them.
Your ‘Financial Advisor’, won’t do any of this.
He is most likely eager to peddle you a financial product that will earn him a
good return. He will do the same with you and 20 other clients he may have.
So eventually, the onus is on you to secure your family’s and your own
financial wellbeing. Remember, this is called ‘Personal’ finance for a reason.
Its best kept personal and dealt with care and diligence.
Good news is, this is not rocket science. If you have the skills to do basic
arithmetic, then half the battle is won. The rest of the work is just the
application part where you’ll figure what is good and what is not.
This is exactly the objective of this module. At the end of this module, you will
be in a position to do these things –
Develop a deeper understanding of financial products and what goes under
the hood
Set up a financial goal and work towards achieving that
Identify financial setbacks and address towards correcting them
I hope you are as excited as I’m about this module!
zerodha.com/varsity
2
3
1.2– I’m not ready yet
Getting my first job was a struggle. I spent 6-8 month meeting tons of people,
desperately looking for a job. I finally landed up with a ‘job’ to do. This was
my first job and it was special. Aer working for a month, I got my first pay
cheque ever and I was ecstatic. I felt responsible for the first time in my life.
I had a bunch of things planned with my first pay. Right from buying my
mother a saree to taking my girlfriend (now my wife) out for dinner J. Being in
a position to do things for your loved ones always feels good.
Aer all the expenses, I still had some money le in the account, albeit very
little.
A good friend of mine suggested that I should invest that money. I brushed
away his advise, thinking that the money le in my account was very little
and would not make any difference whatsoever. However, I convinced myself
that I would start saving next month onwards.
zerodha.com/varsity
3
4
As predictable as it can get, next month to a similar story. I spent all the salary
money and had nothing le to save. No points of guessing, this continued for
years and I never saved a dime.
Even today, I regret doing this. In fact, this probably is one of the top regrets
in my life. I wish I had started saving early on in life.
I’m sure most of your reading this may relate to my story. We all brush aside
saving money today because the ‘amount’ of money we intend to save is very
small. We all keep waiting to receive a sizable amount of money so that we
can start our savings journey with that.
This never happens and unfortunately, we never start saving in life.
Here is an advise – even if it is a small amount, save it. This will make a huge
difference in your financial life.
Allow me to tell you the story of 3 sisters to help you understand why you
need to start saving early in life.
A father had triplet daughters. On their 20
th
birthday, the father declared that
he would pay each daughter a sum of Rs.50,000/- on their birthday, till they
were 65 years old. They were free to use this money in whichever way they
wanted.
As a good father, he also suggested to his daughters that they could invest
this money in a promissory note, which would pay them a return of 12%
compounded year on year, with a condition that once invested, they were
prohibited to withdraw that money till they turn 65.
Although they were triplets, their attitude towards money and savings were
very different. Here is how each daughter utilized this money –
zerodha.com/varsity
4
5
The first daughter started investing right away i.e on her 20
th
birthday. She
invested the first nine 50Ks that she received in the promissory note, and then
the remaining 50K that she received (from 28th birthday to her 65th birthday)
were all spent on frivolous things.
The second daughter initially spent all the money she received. However, on
her 28
th
birthday, she got a little serious. She decided to save the same
amount as her other sister. So she saved 50K from her 28
th
birthday till her
36
th
birthday, and the money she received from 37
th
to 65
th
was spent.
The 3
rd
sister was a bit casual till her 28
th
birthday. She spent all the money
she received from her dad. However, on her 28
th
birthday, she got a little
serious and decided to invest the 50k cash all the way up to 65 years.
Here is a summary of what each sister did with the money –
zerodha.com/varsity
5
6
The first sister saved for the first 9 years (between 20
th
to 36
th
birthday)
totaling Rs.450,000/-.
The 2
nd
sister saved for 9 years (between her 28
th
birthday to 36
th
birthday),
totaling Rs.450,000/-
The 3
rd
sister started saving from her 28
th
birthday, but saved all the way till
her 65
th
birthday, totaling a sum of Rs.1,900,000/-
I have a question for you now – on the 65
th
birthday, which sister do you think
would have saved the most? Remember, once the money gets invested the
promissory note, it gets locked till the 65th birthday and do not forget the
promissory note gives a 12% compounded return year on year.
Pause and think about it for a moment.
zerodha.com/varsity
6
7
Chances are here is how you’d think about this –
The first sister saved too little, very early on, so she would not have saved
much
The 2
nd
sister again has saved very little very randomly, so she may not have
much on her 65
th
birthday
The 3
rd
sister, although started late, has saved quite a bit and continued to
save for the entire duration, hence she must have the highest savings on her
65th birthday
This is expected (in fact I’d be surprised if it is anything else) as we humans
see things in a very linear fashion. Here we equate the future value of our
savings to the amount of money saved today. But there are two other
variables at play here – time and return, both of these when concocted
together, works in a beautiful nonlinear way.
So, here are how the numbers stack up for the 3 sister problem, the numbers
may put you off guard so hold your breath –
The 3
rd
sister saves 19L, which grows to a massive 3.05Crs by the time she
turns 65
The 2
nd
sister saves 4.5L, which grows to an impressive 1.98Crs by the time
she turns 65
The 1
st
sister saves 4.5L, however, she ends up with a whopping 4.89Crs by the
time she turns 65!
Are you confused?
I’m sure some of you are. So here is what I want you to note –
zerodha.com/varsity
7
8
The first and 2
nd
sister saved similar amounts, but the difference was the
amount of time they both gave their money to grow. The first sister gave full
45 years for the investment to grow, but the 2
nd
sister gave only 38 years. See
the difference it makes? This is the reason why I regret not starting to save
early on in my life
The 3
rd
sister ends up with the 2
nd
highest corpus, but for to that happen she
had to save for a very long time. But please note, this still does not match up
to the 1
st
sister’s corpus.
So if you are someone like me, who missed savings during my early days,
then the best option we have now is to save for a really long time.
I hope by now, I’ve convinced you why you need to start saving early. By
starting early, you use time to your advantage and it does play a major role.
Wait for a second – how did I calculate the growth of money for each sister?
How did I figure sister 1 saved 4.89Cr and sister 2 saved 1.98Cr?
Well, this is calculated by applying the core concept of ‘Time value of money’.
Time value of money is the central theme of personal finance. Hence, for this
reason, we need to understand this concept right at the beginning. So in the
next chapter, we will discuss time value and its application in more detail.
Download the excel sheet used in the chapter below.
zerodha.com/varsity
8
9
Key takeaways from this chapter
● Personal finance is best when kept personal to oneself.
● Eventually, you as an individual should be able to build a
financial plan for yourself and your family
● Savings early on in life makes a huge difference in the savings
corpus at the end of the tenure
● Time value of money plays a key role in personal finance.
zerodha.com/varsity
9
10
CHAPTER 2
Personal Finance Math Part 1
2.1 – Simple Interest
When it comes to personal finance, one of the key things to learn is the math
that surrounds this topic. Once you understand the math bit, the rest is just
the application of it and life becomes easy aer that.
In this chapter, I’ll try and explain the most basic math involved starting from
simple interest. I know this is explained across multiple chapters across
multiple modules in Varsity, but for the sake of completeness let me include
all of it in one single chapter.
Let us run through an imaginary transaction, my guess is that this a familiar
situation for most of us.
zerodha.com/varsity
10
11
Imagine that one of your friends needs money urgently and he approaches
you for it. Being a friend, you agree to help him with the money but being a
capitalist at heart, you also expect your friend to pay you ‘interest’ on the
cash you lend to him. I know we don’t usually ask a friend to pay us interest,
but let’s just assume he is a friend whom you’d like to help, but not at the
opportunity cost of your money.
The transaction details are below –
Amount – Rs.100,000/-
Tenure – 5 years
Interest (%) – 10
As you can see, your friend agrees to repay Rs.100,000/- over a 5 year period
and also agrees to pay you an interest of 10%.
Given this, how much money will you make at the end of 5 years? Let’s do the
math and find out the details.
Remember, the yearly interest is paid on the principal amount.
Principal = Rs.100,000/-
Interest = 10%
Yearly interest amount = 10% * 100,000
= Rs.10,000/-
Here is how the math looks –
zerodha.com/varsity
11
Year
Principal
Outstanding
Interest
payable
12
So as you can see, you can earn Rs.50,000/- in total interest from this
payment. The amount you earn from the interest can also be calculated by
applying a simple formula, which you may remember from your school days –
Amount = Principal * Time * Return
Where the return is the interest percentage.
Amount = Rs.100,000 * 5 * 10%
= Rs.50,000/-
I’m sure you’d agree that this is quite straightforward and most of you would
remember that this is simple interest.
In simple interest, the interest gets charged only on the outstanding principal.
Imagine a bank transaction, you deposit Rs.100,000/- in a bank’s Fixed
Deposit scheme, which promises to pay you a simple interest of 10% year on
year for 5 years. At the end of 5 years, you’ll earn Rs.50,000/- as interest
income. The math is still the same.
zerodha.com/varsity
12
01
Rs.100,000/-
Rs.10,000/-
02
Rs.100,000/-
Rs.10,000/-
03
Rs.100,000/-
Rs.10,000/-
04
Rs.100,000/-
Rs.10,000/-
05
Rs.100,000/-
Rs.10,000/-
Total Interest received
Rs.50,000/-
13
Banks don’t pay simple interest, they pay compound interest. What do you
think is the difference between simple interest and compound interest?
2.2 – Compound interest
Compound interest works differently compared to simple interest. If
someone agrees to pay you compound interest, then it essentially means that
the person or the entity is agreeing to pay you interest on the interest already
earned.
Let’s figure this out with the same example discussed above. The transaction
details are as follows –
Amount – Rs.100,000/-
Tenure – 5 years
Interest (%) – 10
Interest type – Compound Interest (compounded annually)
The math is as follows –
Year 1
At the end of 1
st
year, you are entitled to receive a 10% interest on the
principal outstanding and previous interest (if any). For a moment assume
you are closing this at the end of the 1
st
years, then you would receive the
principal amount plus the interest applicable on the principal amount.
Amount = Principal + (Principal * Interest), this can be simplified to
= Principal * (1+ interest)
zerodha.com/varsity
13
14
Here, (1+interest) is the ‘interest’ part and the principal is obviously the
principal. Applying this –
= 100,000 *(1+10%)
= 110,000
Year 2
Now assume, you want to close this in the 2
nd
year instead of the first, here is
how much you’d get back –
Remember, you are supposed to get paid interest on the interest earned in
the first year, hence –
Principal *(1+ Interest)* (1+Interest)
The green bit is the amount receivable at the end of 1
st
year, and the blue bit
is the interest applicable for the 2
nd
year.
We can simplify the above equation –
= Principal *(1+ Interest)^(2)
= 100,000*(1+10%)^(2)
= 121,000
Year 3
In the 3
rd
year, you’d get interest on the 1
st
two year’s interest as well. The
math –
Principal *(1+ interest) *(1+interest)*(1+interest)
zerodha.com/varsity
14
15
The green bit is the amount receivable at the end of 2 years, and the blue bit
is the interest applicable for the 3
rd
year.
We can simplify the above equation –
= Principal *(1+ Interest)^(3)
= 100,000*(1+10%)^(3)
= 133,100
We can generalize this –
P*(1+R)^(n) , where –
P = Principal
R = Interest rate
N = Tenure
So, if you were to have this open for the entire 5 years, you’d receive –
= 100,000*(1+10%)^(5)
= Rs.161,051/-
Contrast the difference between the 50K received in simple interest versus
the Rs.61,051/- received via compound interest.
Compound interest and compounded return work magic in finance. At the
end of the day, every aspect of personal finance boils down to the
compounded return. For this reason, I think it is best to spend some more
time trying to understand the concept of compounding of money.
2.3 – Compounded returns
zerodha.com/varsity
15
16
The concept of compounded return is similar to compound interest. The
concept of return and interest is very similar, just like the two sides of the
same coin. The interest is what you pay when you borrow money in any form
and the return is what you earn when you invest your money in any asset.
Therefore, if you understand interest, then it is easy to understand the return.
In this section, you will learn about how the return is measured. Based on the
time horizon of your investment, the return measurement differs.
You will use the absolute method to measure the return if your investment
horizon is less than a year. Otherwise, if your investment horizon is more than
a year, you will use CAGR or the compounded annual growth rate , to
measure returns.
I guess the difference in absolute and CAGR is best understood with an
example.
Assume you invested Rs.100,000/- on 1
st
Jan 2019 in a financial instrument
which yields you a 10% return (per year) and you withdraw this investment a
year later. How much money do you make?
Quite straight forward as you can imagine –
You will make 10% of 100,000 which is Rs.10,000/-, in other words, your
investment has grown by 10% on a year on year basis. This is the absolute
return. This is straightforward because the time under consideration is 1 year
or 365 days.
Now, what if the same investment was held for 3 years instead of 1 year, and
what if instead of a simple return of 10%, the return was compounded
annually at 10%? How much money would you make at the end of 3 years?
zerodha.com/varsity
16
17
To calculate this, we simply have to apply the growth rate formula –
Amount = Principal*(1+return)^(time)
Which as you realize is the same formula used while calculating the
compound interest. Applying this formula –
100,000*(1+10%)^(3)
= Rs.133,100/-
Referring to the previous section, if you were to charge compound interest,
then this is the same amount of interest you receive from your friend in the 3
rd
year.
Continuing on the same lines, here is another question –
If you invest Rs.100,000/- and receive Rs.133,100/- aer 3 years, then what is
the growth rate of your investment?
To answer this question, we just need to reorganize this formula –
Amount = Principal*(1+return)^(time)
and solve for ‘ return’.
By doing so, the formula reworks itself to –
Return = [(Amount/Principal)^(1/time)] – 1
Return here is the growth rate or the CAGR.
Applying this to the problem –
CAGR = [(133100/100000)^(1/3)]-1
= 10%
zerodha.com/varsity
17
18
2.4 – The compounding effect
Apparently, Albert Einstein once described ‘compound interest’ as the 8
th
wonder of the world. I guess he could not describe it any better. To
understand why you need to understand the compound interest in
conjunction with time.
Compounding in the finance world refers to the ability of money to grow,
given that the gains of year 1 get reinvested for year 2, gains of year 2
gets reinvested for year 3, so on and so forth.
For example, consider you invest Rs.100 which is expected to grow at
20% year on year (recall this is also called the CAGR or simply the
growth rate). At the end of the first year, the money grows to Rs.120.
At the end of year 1, you have two options –
Let Rs.20 in profits remain invested along with the original principal of
Rs.100 or
Withdraw the profits of Rs.20
You decide not to withdraw Rs.20 profit; instead, you decide to reinvest
the money for the 2
nd
year. At the end of the 2
nd
year, Rs.120 grows at
20% to Rs.144. At the end of 3
rd
year, Rs.144 grows at 20% to Rs.173.
So on and so forth.
Compare this with withdrawing Rs.20 profits every year. Had you opted
to withdraw Rs.20 every year than at the end of the 3
rd
year the profits
collected would be Rs. 60.
However, since you decided to stay invested, the profits at the end of 3
years are Rs.173/-. This is good Rs.13 or 21.7% over Rs.60 earnt
because you opted to do nothing and decided to stay invested.
zerodha.com/varsity
18
19
This is called the compounding effect .
Let us take this analysis a little further, have a look at the chart below:
The chart above shows how Rs.100 invested at 20% grows over a
10-year period.
In the next chapter, we will understand the other crucial concept in
personal finance – Time value of money.
Key takeaways from this chapter
● Simple interest is the interest that gets paid only on the
outstanding principal
● Compound interest is paid on both interest and the
principal outstanding
● Interest and return are like two sides of the same coin
● Absolute return is a measure of the growth in return when
your investment if for less than a year
zerodha.com/varsity
19
20
● Compounded annual growth rate (CAGR) is the measure
of your return when your investment duration is more than
a year
● Compounding works best when you give your investments
enough time to grow
zerodha.com/varsity
20
21
CHAPTER 3
Personal Finance Math (Part 2)
3.1 – Money today versus money tomorrow

For a moment, assume a friend of yours is in a very generous mood and
he gives you two offers, of which you have to select one of them.
Option A – He gives you Rs.10,000/- right away
Option B – He promises to give your Rs.10,000/- exactly two year from
now
To add a little twist, assume you do not need the money today, but in two
years, you are planning to buy a new car.
Will you take the money today even though you do not need the money
or will you take the money two years from now, when you would need
the money?
zerodha.com/varsity
21
22
By the way, there is no question of your friend backing out on his
promise after two years, he is a good guy and he will certainly give you
the promised money.
So given these two options, and the other things around it, which one
are you likely to choose?
If I were to guess, most of you reading this will opt for Option B. The
rationale being, that there is no real need for money today, so if you
were to take the money today, you’d spend that money on unnecessary
things and waste the money. Hence you are better off taking that money
two years later.
Assuming the above were to be true, here are few questions to you –
1. Does it make sense to equate money across timelines i.e money
today versus money tomorrow?
2. How do you move money across a timeline to ensure we compare
the right value of money?
To make the right decision, you need to have clarity on moving money
across the timeline. You need to compare the value of money today
versus the value of money tomorrow.
The objective of this chapter is to help you understand just this i.e to
help you compare money across different timelines.
Hopefully, by the end of this chapter, you will be better equipped to make
a sensible decision concerning your friend’s generous offer and of
course for more serious things in life as investment planning J
The discussion we are about to have is a core financial concept called
the ‘ Time value of money ’ (TVM). The time value of money finds its
application across many different areas of finance including project
zerodha.com/varsity
22
23
finance, insurance planning, equity derivatives, valuations, and of course
personal finance.
The time value of money has two components – the present value of
money and the future value of money.
3.2 – Present value of money
We all buy assets with a hope that it will generate a decent return over
time. For example, if I were to buy a piece of land today then I would
expect it to grow to a certain value in 15 years. The amount of money I
will receive when I sell this piece of land in 15 years will have a very
different value when compared to the same value today.
The concept of Present value helps you understand the value of the
funds you are likely to receive in the future in today’s terms.
Sounds confusing? Probably :)
Let’s understand this with an example.
Consider that you purchased a piece of land for Rs.15,000,000/- today
and held it for 15 years. After 15 years, you sell the land at
Rs.75,000,000/-. On the face of it, this looks great, after all, you’ve made
a five times return on this.
But here is an important question you need to ask yourself. How
valuable is Rs.75,000,000/- that you will receive 15 years from now, in
today’s terms?
What if in 15 years from today, Rs.75,000,000/- is less valuable than
Rs.15,000,000/-?
To find the answer to this, we need to understand two thing –
zerodha.com/varsity
23
24
What is my risk-free opportunity cost today?
Given the risk-free opportunity cost, what is the amount that needs to be
invested today, such that it grows to Rs.75,000,000/- in 15 years.
The answer to the 2
nd
question is, in fact, today’s equivalent of
Rs.75,000,000/- that you’d receive in 15 years. So let us figure this out.
We are talking about a 15-year time horizon here.
The opportunity cost is the equivalent of what else can be done with the
funds available if we choose not to invest this money in the real estate
deal. The opportunity cost can be found out by figuring out the risk-free
rate in the economy and adding a risk premium over and above the
risk-free rate.
So the opportunity cost –
Opportunity cost = Risk free rate + Risk premium
The risk-free rate is the rate at which our money can grow without any
risk. Of course, we can endlessly argue that there is nothing like a true
risk-free rate, but for the sake of this discussion, let’s assume that the
risk-free rate is the Government’s 15-year bond. Usually, the
Governments are expected not to default on their payments/repayments,
hence the Government or the Sovereign bond is a good proxy for the
risk-free rate.
Here is a snapshot of all the available Sovereign bonds –
zerodha.com/varsity
24
25
I’ve highlighted the 2034 bond since we are interested in a 15-year time
horizon. As the highlight indicates, the coupon rate is 7.5%. Again for
simplicity, let us keep the bid-ask yield aside, we will anyway discuss
these things in more detail when we deal with bonds. For now, you need
to understand that the risk-free rate for the next 15 years is 7.5%.
To figure out the opportunity cost, we can add a risk premium of 1.5-2%
more. The risk premium really depends on many things, keeping it
simple for now. So, the opportunity cost would be –
7.5% + 1.5%
= 9%.
Now that we have our opportunity cost sorted, we now need to answer
the 2
nd
question i.e to figure the amount that we need to invest today at
9%, such that it will grow to Rs.75,000,000/- at the end of 15 years.
A trial and error method can figure this amount. Alternatively, we can use
the concept of ‘ discounting ’, wherein we discount Rs.75,000,000/- at
9%, which will give us the same answer.
The opportunity cost at which we discount is the ‘ discount rate ’.
zerodha.com/varsity
25
26
By discounting we are essentially equating the future value of money
(Rs.75,000,000/- in this example) to its equivalent value in today’s terms,
also called the ‘ Present Value ’ of money.
The present value forumla is –
Present value = Future value / (1+ discount rate ) ^ (time)
We know,
Future value = Rs.75,000,000/-
Discount rate = 9%
Time = 15%
We can plug these numbers in the equation –
= 75,000,000 / (1+9%)^(15)
= 20,590,353
This means, the present value of Rs.75,000,000/- is Rs.20,590,353/-. In
other words, Rs.75,000,000/- in today’s terms is the same as Rs.
20,590,353/- in 15 years.
Given this, if someone makes an offer to buy the property at
Rs.20,590,353/- today, then it is as good as receiving Rs.75,000,000/- in
15 years, because if Rs.20,590,353/- invested at the opportunity cost of
9%, will yield Rs.75,000,000/- in 15 years.
The concept of present value is very critical in finance and so is the
concept of the future value of money, which we will discuss next.
3.3 – Future value of money
zerodha.com/varsity
26
27
The future value of money is simply the inverse of the present value of
money. Going by the real estate example, the future value of money
helps us find an answer to a question like this –
What will be the value of Rs.20,590,353/- in 15 years from now?
To find an answer to this question, we again must find out the
opportunity cost. Irrespective of future value or present value problems
we are trying to solve, the opportunity cost remains the same.
So, 9% will be the opportunity cost.
To find the future value of money, we must compound the amount at the
given rate of opportunity cost.
Recall from the previous chapter, the compounding formula –
= P*(1+R)^(n), which is also the future value, therefor –
Future value = P*(1+R)^(n)
Where,
P = Amount
R = opportunity cost
N = Time period
Applying this,
= 20,590,353 * (1+9%)^(15)
Now, before I post the answer to the above question, what does your
intuition say the answer is?
Remember, when we worked out the present value of Rs.75,000,000/- at
a 9% discount rate for 15 years, the answer was 20,590,353. Now, we
zerodha.com/varsity
27
28
are trying to do the exact opposite i.e compound 20,590,353 at 9% for
15 years. So the answer has to be 75,000,000. When you do this math –
= 20,590,353 * (1+9%)^(15)
= 75,000,000
This is the future value of money.
So in simple terms, if you had an option to receive 75,000,000 after 15
years or 20,590,353 today, then essentially both of these are the same
deal.
3.4 – The offer
We started this chapter with a hypothetical situation. Your generous
friend gives you two options –
Option A – He gives you Rs.10,000/- right away
Option B – He promises to give your Rs.10,000/- exactly two year from
now
Chances are that you selected option B. However, can we tackle this
situation better? Now that we know the concept of the time value of
money aka the present and future value of money? Of course, we can.
The problem here is that we are trying to compare the value of
Rs.10,000/- today versus Rs.10,000/- two years from now.
Now, if we were to opt for option A, we will have an option to invest this
money in an interest-bearing instrument and grow this money. As of
today, a two year fixed deposit will yield anywhere close to 7.5%. Given
this, we now have to find out the future value of Rs.10,000/- at 7.5%
opportunity rate (or the compounding rate).
zerodha.com/varsity
28
29
= 10000*(1+7.5%)^(2)
= Rs.11,556.25/-
This also means, that if we were to accept option B, we would be
essentially accepting a value much lesser than Rs.10,000/-. A fair deal
here would be either Rs.10,000/- today or Rs.11,556.25/- two years from
now!
This also leads us to one of the most important conclusions in finance –
Money today is far valuable than money tomorrow because today we
have an option to invest this money and grow it at a risk-free rate.
3.5 – Real-life applications
So before we wrap up this chapter, let us consider a few real-life (like)
situations and apply the concept of Future Value (FV) and Present Value
(PV) of money. These are just made-up situations, you will appreciate
the application of FV and PV better later in this module when the
example will be probably more tangible.
Question – So assume you are saving for your daughter’s education at
a foreign university. She is ten years today, and she is expected to go to
the US when she is 25 years old, which is 15 years away. The tuition
fees including the cost of living are expected to be roughly
Rs.6,500,000/-. Given this, how much should you have today?
Answer – When you have a situation like this, the first thing to do is to
figure out if this is a present value or a future value situation. This may
not be very obvious at the surface, so this needs a bit more
understanding. One easy way to figure that out is by analyzing the
numbers.
zerodha.com/varsity
29
30
We know the cost of education in 15 years will be Rs.6,500,000/-, so
what is clear at this point is the future value of our cash requirement.
Given this, we need to figure out the present value of this cash
requirement, so that we can save an appropriate amount today. We can
do this by the simple present value formula we just learned –
Present value = Future value / (1+ discount rate ) ^ (time)
The 7.5%, 15 year Government bond is a good proxy for the discount
rate, so we will use the same.
Present value = 6,500,000/(1+7.5%)^(15)
= Rs.21,96,779/-
So in today’s rate, if we can manage to deposit a sum of Rs.21,96,779/-,
we will have the required target funds in 15 years.
Of course, some of you reading this may be in an exact situation
wherein you’d be saving for your child’s future education. Do note, this is
not the only way to save for it. The different ways to accumulate that
corpus is the objective of this module, but for now, we are only
concerned about gaining clarity about the concept of the present value
of money.
Let us take up an example of the future value of money before we wrap
this chapter up. Here is a situation you may be familiar –
Question – Your dad’s close friend at the office also doubles up as a
wheeler-dealer, and never hesitates to offer a financial deal/scheme. He
comes home for a cup of tea and also decides to sell a financial product
to the family. He says you need to invest a lumpsum amount of
zerodha.com/varsity
30
31
Rs.200,000/- today and in 15 years, the family will get a gain of
Rs.450,000/-.
So will you take up this deal and invest in it?
Answer – This is a tricky question because this can be solved by the
application of both future value and present value concept. We will stick
to the future value application. Quite straightforward this one –
Investment required today – Rs.200,000/-
Expected value from this investment – Rs.450,000/-
Given this, and the 7.5% opportunity cost, we need to figure if this
investment makes sense. We will extrapolate Rs.200,000/- at the
opportunity cost to figure this.
Future value = 200000*(1+7.5%)^15
= Rs. 591,775.5
Contrast this with the Rs.450,000/-, and the deal falls apart. You’ll have
to politely ask your dad’s friend to enjoy his cup of tea and leave.
Now, here is something for you to think about – how will you solve the
above problem by applying the concept of the present value of money?
Think about it and leave your comments below.
zerodha.com/varsity
31
32
Key takeaways from this chapter
● Money today is always more valuable than money
tomorrow because money today can be invested in
interest-bearing instruments
● The time value of money is a core concept of personal
finance
● Time value includes the present value and the future value
of money
● The present value of money helps us figure the value of a
future sum in today’s terms
● Present value = Future value / (1+ discount rate ) ^ (time)
● The discount rate = opportunity cost + risk premium
● Give a certain amount of money today, the future value of
money helps us figure out its value at a future date
● Future value of money and the compound interest concept
works the same way
● Future value = P*(1+R)^(n)
● R in the above formula is the opportunity cost, whereas
the R used in compound interest is the growth rate. This is
the only difference between Future value and compound
interest.
zerodha.com/varsity
32
33
CHAPTER 4
The retirement problem (Part 1)
4.1 – Defining the problem
If you think about it, success in personal finance boils down to three things –
Your ability to see through the numbers
Your risk-taking ability, and
Common sense
I hope that the previous two chapters have laid down a foundation, which will
help you look through the numbers.
The risk-taking ability is merely a function of your knowledge and the way you
continuously expand it. The more you read and understand, the more you get
familiar with risk and the better equipped you are to handle risk. The extent
of risk you assume can make or break your financial fortunes. Of course, we
will discuss more as we proceed through this module.
Common sense is something applicable to all aspect of life and not just
finance; we will leave it at that
🙂
So, given these three key points, we will now steer our way into learning the
vast set of things that make up personal finance, and hopefully, this will help
us develop our instincts on all the three counts required for success in
personal finance.
zerodha.com/varsity
33
34
Finding a starting point to start this journey is a challenge given that the
vastness of this topic. Hence, in my opinion, the best way to proceed is by
identifying a real-life financial problem and then finding a solution for it.
The process of finding the solution will open up many different learning
windows, which will help us understand the core concepts of personal
finance.
So let’s get started.
I’m assuming most of you would be in different stages of your working life,
some would be starting (or about to begin your careers), some may be few
years into work life, and others probably halfway through your work life.
Regardless of where you are, one of the common goals in life is to ensure that
you retire into a happy and content life. The fact that you have retired should
not stop you from leading a particular desired lifestyle. You should continue
to lead a lifestyle that you think you deserve.
If the above is true, then it implies that you need the same amount of
disposable income, as you would have when while you were working. Lesser
disposable income wants a compromised post-retirement lifestyle, which
none of us wants.
zerodha.com/varsity
34
35
Let us put this in context and assign numbers to it, and elaborate this a bit
further.
Assume you will work for the next 25 years (these are your income-generating
years), post which you will retire. Aer you retire, you expect to live for say 20
more years. Assume, the cash required today to lead your lifestyle is
Rs.50,000/- per month. This is cash post taxes, fixed expenses, utility bills, etc.
This is your disposable income per month.
The idea is that aer 25 years, for the next 20 years of your post-retirement
life, you’ll need the same Rs.50,000/- every month, this is about Rs.600,000/-
per year.
zerodha.com/varsity
35
36
Some of you may disagree or may have a different opinion on how much you
need post-retirement; I understand that but stick with for now, please.
Let me put this tabular format for you to understand this better –
I’m sure all of you reading would agree that this is a real-life problem and we
all need to address this.
If you think about this, there are two parts to this real-life problem –
How much retirement corpus one needs to have accumulated by the time of
retirement, i.e. the beginning of the year 2044?
How does one accumulate the required money?
Some of you may be tempted to answer the first part straight away –
zerodha.com/varsity
36
Current year
Number of working
years
Year of retirement
Number of years
post-retirement
Final year
Monthly cash
requirement
Yearly cash requirement
37
It is Rs.600,000/- per year (50,000 per month for 12 months) and for 20 year it
is Rs.12,000,000/- (600,000 * 20) or 1.2Cr. So if we were to accumulate a
retirement corpus of 1.2Cr by the year 2044, we could easily sail through the
next 20 years of post-retirement life by burning Rs.50,000/- per month, all the
way to 2063.
Well, if only life was that simple J
Given the above, the question is, how much cash reserves you’d need at the
end of 25 years, i.e. in the year 2044, such that you can have Rs.50,000/- every
month till the year 2064.
In this chapter, we will address the required corpus bit and figure out the
amount needed at the start of the retirement year. In the next section, we will
figure out how this corpus gets generated.
4.2 – Inflation and other realities of life
In the absence of inflation, the math above would work like a charm, i.e. in
the year 2044, a sum of Rs.12,000,000/- would help us sail through our
retirement years at ease, i.e. at the rate of Rs.50,000/- per month up to 2064.
However, inflation is real, and this makes life complicated in multiple ways.
Inflation is the phenomenon, which makes things expensive. For example, a
plate of pav bhaji at a restaurant may cost Rs.50/- today, but the same may
cost Rs.55/- at the very same restaurant the next year. This marginal increase
in cost is attributed to inflation. In other words, the purchasing power of
money has reduced over one year.
zerodha.com/varsity
37
38
This is true, all else equal, money today will always be less valuable at a
future date. For this same reason, all the stories of our parents and
grandparents enjoying a full meal for less than Rs.2/- exists J
This implies, today’s Rs.50,000/- will not be Rs.50,000/- tomorrow. It will
naturally reduce owing to inflation. For this exact reason, we cannot only
multiply the amount required with the number of years and arrive at a figure.
4.3 – The Future value
To find a solution, we need to find out the Rs.50,000/- equivalent 25 years
from now. This is what we learned in the previous chapter.
The expected cash requirement is as shown below –
zerodha.com/varsity
38
Year of
retirement
Year
How many
years away
Corpus required as per
today’s value
01
2044
25
Rs.600,000/-
02
2045
26
Rs.600,000/-
03
2046
27
Rs.600,000/-
04
2047
28
Rs.600,000/-
05
2048
29
Rs.600,000/-
06
2049
30
Rs.600,000/-
07
2050
31
Rs.600,000/-
08
2051
32
Rs.600,000/-
39
The table is quite easy to understand. Look at the first row, it says, the 1
st
retirement year is 2044, and it is 25 years from the current year i.e.2019. The
corpus required for 2044 is Rs.600,000/-. This is a constant amount needed for
all the retirement years.
The 2nd retirement year is 2045, which is 26 years away from the current year
(2019). So on and so forth.
zerodha.com/varsity
39
09
2052
33
Rs.600,000/-
10
2053
34
Rs.600,000/-
11
2054
36
Rs.600,000/-
12
2055
37
Rs.600,000/-
13
2056
38
Rs.600,000/-
14
2057
39
Rs.600,000/-
15
2058
40
Rs.600,000/-
16
2059
41
Rs.600,000/-
17
2060
42
Rs.600,000/-
18
2061
43
Rs.600,000/-
19
2062
44
Rs.600,000/-
20
2063
45
Rs.600,000/-
40
Now the task at hand is to estimate the value of Rs.600,000/- 25 years later, 26
years later, 27 years later, and for each year up to the final year, given a certain
level of inflation. Remember, these are all the future value of money.
4.4 – Estimating the future value of the corpus
To proceed further from this point and estimate the corpus required at the
start of the retirement year, i.e. 2044, we need to have a view on the long-term
inflation.
I would be comfortable pegging the long-term average inflation value
between 4-5%. Now, the question to answer is – given 5% inflation, what
would be the value of Rs.600,000/- 25 years from now.
Similarly, given 5% inflation, what would be the value of Rs.600,000/-, 26
years from now, so on and so forth, all the way to the 20 years of retirement.
If you recollect from the previous chapter, we are talking about the future
value calculation here. Once we have all the future values, we need to sum
them up to get the total corpus required at the start of the retirement year.
Let us do this for the initial 2-3 years and then take the help of MS Excel to
figure the rest.
From the previous chapter, the future value formula is –
Future value = P*(1+R)^(n)
Where,
P= Principal i.e. Rs.600,000/-
R = opportunity cost, in this context it is the inflation rate, so 5%
zerodha.com/varsity
40
41
n = Period, 25 in this case
Plugging in these value –
600,000*(1+5%)^(25)
= Rs.2,031,813/-
So, in 25 years, if you have Rs.2,031,813/-, then it is as good as having
Rs.600,000/- today.
For the 2
nd
year –
600,000*(1+5%)^(26)
= Rs.2,133,404/-
So, in 26 years, if you have Rs.2,133,404/-, then it is as good as having
Rs.600,000/- today.
So on and so forth.
Here is an excel snapshot that shows how the numbers stack up for all the
other years, but before you look at it, can you guess how much this amount
can be?
For most people I’ve asked this question, they get the value way off the mark,
this is because they cannot comprehend the fact there is inflation and
compounding (future value) at play here.
So go ahead and give it a shot, take a guess on how much the retirement
corpus should be, once you’ve answered this, then take a look at the actual
number; hopefully, it should match, if not, don’t worry, we all have some
learning to do.
zerodha.com/varsity
41
42
As you can see, the corpus required at the start of the retirement year is a
staggering 7.2Crs!
The numbers drastically change if we change the inflation assumption and of
course the actual amount of our lifestyle demands.
4.5 – Oversimplification
Some of the things are oversimplified and exaggerated here. For instance,
having a constant monthly requirement of 50k may not be accurate. As we
age, we would prefer to sit at home and sip a drink as opposed to hanging out
in the coolest and trendiest bar in town. Or we may cut down on all the
outside eating, watching movies, etc. We may not want to buy the latest
denim from levis or the newest pair of sneakers from Nike. Who knows?
zerodha.com/varsity
42
43
Our requirements could be very different, and from whatever I’ve read,
observed, and understood, the money required for older people is lesser than
the younger ones. So we may not need 50K per month when we retire.
But here is the thing with personal finance, it is best to take a conservative
approach and figure out the outcome. If we manage to lead a comfortable but
yet a frugal life at a later point, its great, else we would have anyway
budgeted for it.
In the next chapter, we will understand ways to generate this income.
Download the excel sheet used in this chapter here.
Key takeaways from this chapter
● Retirement is a real-life financial problem that we all need to
address
● Inflation complicates things. Money today is not the same
tomorrow
● The inflation diminishes the purchasing power of money
● Use the future value of money to estimate the worth of money
today, ‘n’, many years later.
zerodha.com/varsity
43
44
CHAPTER 5
The retirement problem (Part 2)
5.1 – Assumptions
We are at an exciting point now. The previous chapter helped us estimate
(roughly) the corpus required for one to retire comfortably, without
drastically changing the post-retirement lifestyle.
One can argue that certain aspects were overlooked while estimating the
post-retirement corpus, which is ok for now because this helps us determine
the retirement corpus on a conservative basis.
The idea, of course, is to understand personal finance so well that we can
plugin things as we progress and eventually get the corpus number right.
In the previous chapter, we figured that we need roughly 7Cr by retirement; in
this chapter, we address the technique to generate the same. It must be quite
evident to you by now that to create the retirement corpus by the target
retirement year; we need to make investments starting today.
The investments that we make today should ideally spread across multiple
assets. This is called the multi-asset portfolio, which includes – fixed deposits,
gold, real estate, equities, cash, and cash equivalents. The overall growth that
you experience will then be an aggregate across all these assets.
zerodha.com/varsity
44
45
Let me explain a bit more before we get back to the retirement problem.
Assume your net worth is distributed across multiple assets –
30% of your net worth is invested in real estate
8% of your net worth is in the fixed deposit
8% of your net worth is from gold
13% of your net worth is in equities
Cash is 4%
The numbers assigned are all arbitrary, to drive the concept, so don’t sweat
over it
🙂
Now, each of these assets grows at a specific rate. Needless to say that the
growth rates differ for each of these assets. The question is, what is the
overall growth given this portfolio of assets?
To answer this, we need to have an expected growth rate for each of these
assets.
zerodha.com/varsity
45
46
My long term (10 plus years) growth expectation (CAGR) from these assets are
as follows –
Real estate – 8-10%
Fixed Deposit – 6-7%
Gold – 8-9%
Equities – 10-11%
Cash – 0% (in fact cash de grows if you consider inflation)
You can develop your own opinion on the growth rates for these assets by
looking at the long-term trends and by developing an idea on their future
performance. But here is an advise, when you work with
predictions/projections of any sort in personal finance, always keep the
number on a conservative basis.
For example, frankly, I know equities, in the long run, will do much better
than 11% CAGR, but I’ll work with a 10-11% range. The advantage here is that
you build a future based on conservative assumption, anything better is only
a bonus.
Anyway, the overall portfolio growth in the sum product of the weight of each
asset and the expected return. Therefore –
= 30% * 10% + 8% * 7% + 8% * 9% + 13% * 11% + 4%* 0
= 8.3%
So as you can see, the combined (diversified) portfolio with multi-assets,
generates an overall return of 8.3%.
zerodha.com/varsity
46
47
Of course, change in asset allocation has an impact on portfolio growth. We
have discussed this multiple times, won’t get into that discussion now.
By the way, check this to know how people generally divide their net worth
across a diverse set of assets –
The infographic above mainly talks about the HNI and above category;
however, if you walk into any financial planning firm, you are likely to get a
somewhat similar diversification plan.
zerodha.com/varsity
47
48
While a multi-asset portfolio is highly desirable, we won’t get into that
discussion just yet. This is slightly complex, and we are too early in this
module to talk about it.
For the retirement problem, we will make one fundamental assumption. The
assumption is that we will look at only equity for building the retirement
corpus. The exposure to equity is in the form of making systematic
investments in a growth-oriented equity mutual fund.
If you do not understand ‘systematic investments in a growth-oriented equity
mutual fund’, then do not worry. Going forward in this module, we will
discuss this in detail.
Since equity is the only asset we are dealing with in this retirement problem,
we need to assign an expected growth rate to this asset. I think a 10-11%
CARG is a fair expectation, especially when the holding period is long, i.e.
more than ten plus years.
So let’s work with this number for now.
5.2 – The setup
A quick recap of the retirement problem, before we proceed. In the previous
chapter, we figured that we need funds to the tune of 7Crs to lead a
comfortable retired life. We call this a retirement corpus. We defied
‘comfortable’ by ensuring we have at least Rs.50,000/- per month for the 20
years post-retirement.
The next step is to figure out how one can generate a retirement corpus.
Remember, we are starting our journey to save for retirement today, and we
have 25 years to build this corpus. Twenty-five years is 300 months.
zerodha.com/varsity
48
49
For now, we will rely upon investing in an equity mutual fund, in a systematic
way to generate this retirement corpus. To solve this problem, we need to
make a few assumptions. They are –
We have a steady job which pays us a salary every month
We are employed until the year of our retirement
Our primary savings vehicle is regular investments in equity mutual funds
We get yearly hikes in our pay
Every year we will increase the investments in equity mutual funds by 10%
The increase in savings happens every January
I know many of you may be concerned with these assumptions here,
especially about the job and the hikes, but then, that’s an underlying
assumption, without which we cannot proceed
🙂
So how do these assumptions translate to action? Here is how it looks –
Let me explain this table. The very first row reads like this –
zerodha.com/varsity
49
50
It is January, and I’m making my very first investment of Rs.5000/- today. I
won’t be touching this investment until I retire, which is 25 years away or
about 300 months away.
The 2
nd
row reads similar – Its February, I’m making the 2
nd
savings
installment for the year, i.e. Rs.5000/-. Retirement is now 299 months away.
I want you to recognize the fact that the ‘months away’ can be looked at from
a different perspective. If you realize, these are the number of months during
which your money can grow. For example, the very first installment you make
has the luxury to build (or compound) for 300 full months. The next month’s
savings can grow only for 299 months, 3
rd
installment has only 298 months to
grow. So on and so forth.
Now, the 5
th
and 6
th
assumptions state that we are increasing the savings rate
by 10% every January. This means, if we are starting with Rs.5000/- for year 1,
the 2
nd
year we bump this up by 10%, hence for the 2
nd
year we invest
Rs.5,500/-.
This is how it looks –
zerodha.com/varsity
50
51
The month counting continues the same way. For example, the Rs.5,500/-
investment we make in the 2
nd
year January has only 288 months to grow or
compound.
I hope you get this flow for now.
So what happens aer you make these investments? Well, as per the
assumption, each of these monthly investments we make, grows at 11%
CAGR (compounded annual growth rate), for the respective months.
zerodha.com/varsity
51
52
For example, the very first investment that we make, i.e. Rs.5000/- gets to
grow at the rate of 11%, for 300 months. So what would be the value of this
investment at the end of 300 months?
Well, by now, you should recognize that we can apply the concept of the
future value of money and get the answer. The future value of money formula
is –
Future value = P*(1+R)^(n)
Where,
Principal ( P ) = Rs.5000
Growth rate ( R ) = 11% per annum
Time ( n ) = 300 months. However, this formula considers time in years. Hence
we need to express 300 months in years, therefore 300/12 = 25
= 5000*(1+11%)^(300/12)
=Rs.67,927/-
Let us do this for the 2
nd
installment as well; everything stays the same except
for the time component –
= 5000*(1+11%)^(299/12)
= Rs.67,339/-
This is how the table looks –
zerodha.com/varsity
52
53
Now, if you add up all the future values, you get the corpus accumulated for
your retirement. Before I show you the number, what is your guess? Does
Rs.5000/- as the starting amount make the cut? Do you think it gives you the
target corpus of Rs.7Crs?
If you are doubtful, then you are right. It does not cut the mark. It’s way off
the mark –
zerodha.com/varsity
53
54
So what should we do? How do we ensure we reach the target retirement
corpus? Well, we can do three things –
We save for a much longer period, say 30 or 35 years. However, this may not
be viable as we won’t have a sustainable source of income for these many
years
Increase the rate of return, maybe from 11% to 14%, but then is like robbing
yourself of your future. So we won’t commit this sin
Increase savings, this means a frugal life today for a comfortable and
financially independent life tomorrow. This is an option we can work with
this.
So from saving Rs.5000 per month, let us bump this up to say Rs.15,000/- per
month. Here is how the numbers stack up –
There is a significant improvement, but still not close to the 7Cr mark. We can
try this with Rs.20,000/-
zerodha.com/varsity
54
55
As you can see, starting at Rs.20,000/- per month, we get close to the 7 Cr
mark, which upon retirement will yield us Rs.50,000/- per month for 20 years.
5.3 – Are you serious?
Saving Rs.20,000/- a month, that too as a starting amount may sound crazy to
many, especially for people who are just starting their careers. Aer all,
you’ve just started your career, started seeing a steady cash flow, and you are
expected to park the bulk of it for retirement?
How fair is that?
Before it demotivates you any further, let me tell you. It is not all that lousy
🙂
Let me make an assumption here; if you are starting your career now, then
probably you are 24 or 25 years old. This means you have a long runway
before you retire. Even if you retire by 60, you mostly have 35 years to retire.
Out of these 35 years of service, even if you invest for 30 years, you will be
placed much better. You can choose to start with Rs.10,000/- per month.
Check the snapshot –
zerodha.com/varsity
55
56
Starting your career early, gives you two powerful levers to operate – time
and money. You can start with a small amount and build on it, eventually, it
will yield you a similar result.
What if you are in the middle of your career and you are looking at retirement
sometime over the next 10 or 15 years? Well, unfortunately, you do not have
many options expect to save large chunks of your cash flow.
But remember, this entire conversation is an oversimplification to help us get
started. There are many angles to this story. For example, you may acquire
property by inheritance, which earns you a rental income for the rest of your
life or you can get a huge lump sum amount at retirement, thanks to PF and
stuff. This retirement amount gets parked in a savings account or a fixed
deposit, which gives you yearly cash flow.
The objective of this module is to help you solve this puzzle so that you can
plan your financials efficiently for yourself and your family.
5.4 –Next step
Irrespective of the lump sum cash or a yielding rental property landing up in
your lap by retirement, investing in equity is something that you cannot miss.
zerodha.com/varsity
56
57
I firmly believe that ‘equity’ as an asset class will outperform all other assets
and shine through. Equity has to be a part of your long term portfolio.
The best way to gain exposure to equity is by investing in mutual funds via a
systematic investment plan. Of course, there are many other variants and
techniques for this.
Given this, over the next few chapters, we will deep dive into mutual funds
and get a thorough understanding of mutual fund investing. This discussion
will include things like developing a mindset for mutual fund investment,
building a mutual fund portfolio, goal-based portfolio, fund analysis, direct vs
regular, growth vs dividends, etc.
Once we understand mutual funds, we will steer our way to learn other
critical components of personal finance such as life insurance, health
insurance, pension funds, EPF, ETFs etc.
So as you can imagine, we have a long learning path ahead
🙂
Key takeaways from this chapter
● In a multi-asset portfolio, the aggregate portfolio return is the
sum product of the asset weight and the asset’s expected
returns
● Equity exposure is a critical component in long term wealth
creation
● Investing small amounts of money regularly leads to a massive
retirement corpus
zerodha.com/varsity
57
58
CHAPTER 6
Introduction to Mutual Funds
6.1 – Flashback
The retirement problem chapter has laid down a learning path to understand
personal finance. We know now that to build a retirement corpus, long-term
investments in mutual funds is inevitable. Given the pivotal role mutual funds
plays in defining our financial welfare, it is completely justified to spend some
time to learn about mutual funds. The learning that I’m talking about is
something that goes beyond normal mutual fund investors would know. The
objective here is to help you know the basics plus a little more. Hence, the
topics I’d like to cover here are –
What is a mutual fund?
Who runs a mutual fund and why?
Regulatory aspects around a mutual fund from an MF investor’s perspective
The different types of mutual funds – Equity, Debt, FoF, Hybrid, Liquid
How to analyze a mutual fund? – Risk, return, ratios, exposure
Factors that matter – MF ranking, Direct vs Regular, Growth vs Dividend
Setting long term return and risk expectations
Constructing goal-based mutual fund portfolios
Logistics – SIP, SWP, STP, CAS statements, DEMAT vs non-DEMAT mode
Tracking investments
Mutual fund taxation
zerodha.com/varsity
58
59
Of course, I will add more topics if there is a need for it.
Given this, let us get started on the very first topic i.e. to understand what a
“mutual fund” really means.
I’m making an assumption here that you know nothing about mutual funds.
I’m assuming that this is your very first attempt to learn about mutual funds,
hence we are starting from scratch. You can skip this chapter if you know
what a mutual fund is.
Before we start learning about Mutual funds, I’d like to digress a bit and
narrate a personal story dating back to 2008-09.
I’m not sure how many of you reading this were trading, investing, tracking or
remotely connected to the stock markets in the year 2008. The year 2008 was
very interesting (perhaps scary) for people sitting on the sidelines and
watching all the action, but for people involved and had their livelihoods tied
to the market, 2008 was apocalyptic. The financial services industry was in
absolute pits, and I was in the city of London, which was the epicentre of the
financial meltdown. I was relatively new in the industry, had very few industry
connections, and hardly any working experience in the UK. When the
industry-wide job cuts started, I knew it would be me sooner or later. The
good thing was I just dint sit on the sideline wondering if I would get the
layoff notice. I knew it was a matter of time.
Given the situation, I had decided to head back to India. Of course, not that
there many options for me to choose.
By Feb 2009, I was back in Bangalore, luckily I found myself a spot to sit and
trade the markets with the (now) legendary Kamath Associates (pre-Zerodha
zerodha.com/varsity
59
60
days). Soon, I was in the thick of the action and I was trading anything and
everything that moved on the Indian exchanges.
The capital to trade was mainly my own plus a bit from my close circle.
While trading was something I enjoyed, I found investing super interesting. I
spent a lot of time reading the annual reports and understanding of
businesses. This effort included learning a bit of accounting to help me read
the company’s financial statements. I soon realized that stock picking and
building long-term equity portfolio was something that I wanted to for a
living.
I slowly branched out from active trading and started building an investing
practice. I moved out of Kamath Associates to do this full time. Of course, at
that point, Kamath Associates dissolved and Nithin Kamath started Zerodha.
Over time I built a carefully craed equity portfolio for myself. I had a thesis
for each investment made. I was aware of the growth drivers and the risk
parameters for each stock I had invested.
While I started doing this for myself, I soon extended my help in setting up an
equity portfolio for my family members and later to my close friends. I had
few things going right for me and soon people around me and their
immediate circle knew I was a good option to consider for equity investing. It
was in November 2010, that I decided to do this as a profession.
My idea was to help people build an equity portfolio, manage it on their
behalf, grow it, review it periodically, assess the risk, and do everything
possible with a single point agenda – to help them generate wealth over a
long period.
zerodha.com/varsity
60
61
In short, I wanted to be a ‘Fund Manager’, help people build wealth by
investing their money in the stock market.
I continued my journey, by 2012, I was fortunate enough to onboard a bunch
of clients and managed a decent sum of money. I was taking an independent
decision on which stock to invest in and which stocks to exit. I was deciding
how much to invest in each stock and for how long. On the first Saturday of
every month, I’d send a report to all my clients informing them of how their
portfolio was performing in the market.
I was indeed a fund manager for at least 20-25 families, and I felt happy and
responsible being in that position.
However, there was a problem lurking. As per the regulators, i.e. SEBI, anyone
aspiring to be a fund manager and manage portfolios, had to procure a
license from SEBI. This license is called the ‘Portfolio Management Service’
(PMS) license. Probably I’ll discuss PMS later in the module. Given my
situation, the cost of applying for this license and the associated net worth
zerodha.com/varsity
61
62
requirements was prohibitive. Hence, I was forced to shut shop in the
subsequent years and return the investment capital to the clients.
Anyway, thanks for reading through my rather boring flashback, but I had a
reason to share this with you. I want you to identify a few things. As a
self-proclaimed fund manager, I was trying to –
1. Researching stocks
2. Build an investment thesis for each stock
3. Estimate the amount of money to invest in each stock
4. Build an equity portfolio
5. Track individual stock and overall portfolio
6. Measure the returns, performance, and risk at periodical intervals
7. Report to clients
The points mentioned above captures the role of a typical fund manager. At
this point, I want you to be very clear about the role of a fund manager.
Also, a quick reminder – we are in the process of understanding what ‘mutual
funds’, means and I hope I’m heading in the right direction, so please do stay
with me on this
🙂
6.2 – Large scale fund manager
I guess most of us at some point would have paid a visit to the neighborhood
bakery to buy either a loaf of bread or a pack of biscuit baked by the baker.
These biscuits usually have a local and unique taste to it, not available
elsewhere in the city. It is a local thing. It is nearly impossible for a person in
another city to source the same biscuit.
zerodha.com/varsity
62
63
However, think of the biscuits made by Britannia, a large-scale biscuit and
cookie manufacturer. It does not matter whether I’m in Bangalore or Delhi.
The same Britannia biscuit is available throughout the country. It tastes the
same, has the same packaging, looks identical, and weighs the same. Not a
grain of salt or sugar varies from one pack to another. It is a highly
standardized offering.
Britannia is a large-scale baker, with a distribution network across the
country. The baker in your neighborhood is a local baker, with the residents
as his loyal customers. He does not have a distribution network like Britannia.
Now think about my ‘fund management’ affair, I guess you would agree that I
was comparable to the local baker, catering to a small set of customers in the
neighborhood.
On similar lines, there are “fund managers”, on a large-scale basis who can
cater to millions of customers and offer the same service to each one of these
customers.
Customers in the fund management context are people who are looking for
‘fund management’, services.
These large-scale fund managers typically operate via a mutual fund
structure. Think of the mutual fund structure as a method to offer fund
management at scale. I will shortly discuss this in more detail, but before
that, let us draw a quick analogy to reestablish the things we have learned so
far –
zerodha.com/varsity
63
64
At this point, all I want you to understand is this –
1. A fund manager is responsible for your funds
2. An Asset Management Company (AMC), is a company where a fund
manager works and manages your money
3. Think of the ‘Mutual Fund structure’, as a vehicle or mechanism to
manage your funds
I hope so far so good. We will now proceed to understand how a mutual fund
company is structured and functions. I understand that you do not need to
know about this, as long as you know how to invest in a mutual fund. Fair
enough, but I have a slightly different objective here i.e. to make you a little
more knowledgeable than a normal MF investor.
It is like this, you can buy a DSLR camera, turn on the auto mode and start
clicking the pictures. Chances are you will end up taking decent pictures.
However, if you take the effort of knowing a little more about your camera,
you may end up using your camera more efficiently, which may perhaps
result in a brilliant photograph.
Therefore, in my opinion, knowing a bit about the structure of an AMC will not
go waste. It is one of those ‘good to know’, things in life
🙂
zerodha.com/varsity
64
65
6.3 – Deconstructing an AMC
Setting up an Asset Management Company (AMC) is a very daunting task. You
cannot wake up one day and decide to start an AMC. There are prerequisites
to set up an AMC and these prerequisites are laid down by ‘The Securities and
Exchange Board of India’ (SEBI). SEBI is the governing authority for all the
AMCs in India. SEBI holds the rights to grant or not grant the AMC license to a
corporate body.
The process of setting up and AMC is highly stringent and rightfully so. Aer
all, there is a large scale public money at stake and the regulators need to
ensure this money is managed by responsible entities.
In their effort to bring in transparency and accountability, SEBI has proposed
a multi-tier structure for an AMC. Here is the structure of an AMC –
Fund sponsor – Think of the fund sponsor as the main promoter of the Asset
Management Company. The fund sponsor is a corporate body, which
zerodha.com/varsity
65
66
expresses a desire to set up an AMC. The fund sponsor approaches SEBI for
setting up the AMC. The fund sponsor has to follow the 2 stage application
process by furnishing all the details SEBI would require. At the end of stage 1,
SEBI either denies the licenses or grants an ‘in principle’, approval for the
same.
Once the in-principal approval is issued, SEBI demands more documents and
details for further scrutiny. Finally, aer the stringent due diligence process,
SEBI can again decide to either grant or deny the AMC license to the fund
sponsor.
Trustees – Once the fund sponsor procures the license from SEBI, they need
to register a trust and appoint a board of trustees. The trust ensures that the
AMC formed by the fund sponsor carries out its duties in the right spirit and
works in the interest of the clients of the AMC (unit holders). SEBI also
mandates that the trustee of the fund is independent and not associated with
the sponsor in any way.
AMC – The trust in consultation with the fund sponsor appoints an AMC. The
AMC is also called the ‘Investment Manager’. The role of the AMC is to float a
mutual fund and manage the different investment schemes of the AMC. The
AMC houses a chief investment officer (CIO), fund managers, analysts, and
everyone responds to run and manage the mutual fund. The AMC is
responsible for the operation and management of different mutual fund
schemes, in compliance with the SEBI’s rules and regulations.
Think of the AMC as the core engine responsible for running the mutual fund
show.
zerodha.com/varsity
66
67
Custodian – The AMC now appoints a custodian. A custodian’s job is to hold
all the shares that the mutual fund buys. Think of the custodian as the safe
keepers or the guardians of the mutual fund assets.
RTA – The ‘Registrar and Transfer Agents’ is appointed by the AMC. The RTA’s
job is to ensure that they serve the clients of a mutual fund (unit holders). The
services here include issuing folio numbers, transfer of unit, etc.
The custodian and the RTA are called the ‘service provider’, for the AMC
company.
All the parties involved work in synch to run the mutual fund company. For
you as an investor, the only two things that matter is –
Who is the sponsor of the AMC, this is to ensure you are dealing with credible
names
Who the fund manager is – to ensure the money is handled by the right
person
Anyway, let us put all of this information in context before we wrap this
chapter.
zerodha.com/varsity
67
68
As you can see, these details belong to the Aditya Birla AMC.
There are two sponsors here i.e. Aditya Birla Capital Limited and Sun Life
(India) AMC Investments Inc. These two companies have jointly approached
SEBI to procure an AMC license. Since there are two fund sponsors, this is a
joint venture and the shareholding is as follows –
The sponsors, aer obtaining the AMC license have floated Aditya Birla Sun
Life AMC Limited, which is the name of the investment manager or AMC.
They have also formed a Trustee company called, the Aditya Birla Sun Life
Trustee Private Limited.
The details of the service provider are as follows –
zerodha.com/varsity
68
69
As you can see, the company as appointed, two custodians (Citi and
Deutsche) and 1 RTA (CAMS). Besides, there are other details on the bankers
and auditors.
zerodha.com/varsity
69
70
Key takeaways from this chapter –
● A fund manager is responsible for managing the mutual fund
● The sponsor of the AMC is like the promoter of a mutual fund
● The sponsor holds the AMC license
● The sponsors appoint a trustee and AMC company
● AMC is the investment manager responsible for running the
mutual fund
● Custodian appointed by the AMC is responsible for holding
shares and other assets of the AMC
● The RTA is responsible for servicing the AMC’s unitholders
zerodha.com/varsity
70
71
CHAPTER 7
Concept of fund & NAV
7.1 – The Family pot
I hope the previous chapter helped you understand the structure of a Mutual
Fund company. Although not essential, I believe that the understanding of
the Mutual fund structure will help you at some point in your investment
journey.
Moving ahead, we direct our efforts to learn more about Mutual fund
investing. We will learn about the different fund category, fund analysis, fund
schemes, and many other things associated with mutual fund investment.
Now, before we learn these concepts, we need to understand a fundamental
concept. From my observation, I’ve noticed that many people get a bit lost
when we use the term ‘fund’ in the context of a mutual fund.
So before we start digging deeper into the mutual fund concepts, we must get
complete clarity on what the term ‘fund’ means.
I will take the liberty to simplify many things in this chapter; the
simplifications in this chapter are only to help you get the context right.
So let us started, and as usual, let us build an imaginary story to help relate to
the topic better.
Now, think of yourself as the stock market whiz-kid in your family. You have
made a few successful stock investments, managed to score few
zerodha.com/varsity
71
72
multi-bagger, called the market top and bottom couple of times, and have
even managed to get a selfie with Rakesh Junjunwala at an event.
The story of your stock market success has sent a ripple in your family circuit,
and you are even the centre of attention in the family WhatsApp group.
As expected, soon, your uncles, aunts, and cousins approach you to help
them manage their money. The quasi fund manager status that you have
achieved for yourself has gotten you all excited.
The question is – how will you manage this money?
Going strictly by regulations, unless you hold the license for fund
management, like the PMS license we discussed in the previous chapter, you
cannot manage other people’s money.
Given this, assume that you apply for a fund management license and
eventually procure one from SEBI.
Now, you are all set to render your fund management services to your family
members and hopefully soon to many others outside the family.
Your family members are happy and are eager to reap the benefits of your
fund management skills. The following family members approach you with
their money. The details follow –
zerodha.com/varsity
72
73
So you have five individual investors and each one of them has a different
amount of money to invest. In total, across these five individuals, you have
managed to pool in Rs.275,000/-.
Before you get started, you need to set a few expectations –
All investors are treated fairly in terms of return generated
You are permitted to treat these individuals differ in terms of service
provided. For example, the aunt has invested the highest amount, so maybe
when she visits, you can give her coffees and cookies, while the nephew has
invested the least, so you can decide not to offer the coffee and cookies
The above two are critical points, let us spend a bit more time to rivet it.
Imagine you and I walk into a restaurant. You are a regular at the restaurant
have been to the restaurant multiple times and have generated enough
business for the restaurant. However, this is my first visit to the restaurant.
We both end up ordering a portion of biryani. The quality and quantity of the
biryani we both get served will remain the same. However, since you are
zerodha.com/varsity
73
74
regular, the owner himself may decide to serve you with fine silver cutlery,
and the owner may even spend a few minutes chatting about your
well-being. On the other hand, I’d be served with regular cutlery and treated
like a regular customer.
However we both get to eat the same dish, no difference there.
So you as a fund manager can differentiate between customers on how much
they have invested, but should certainly not differentiate and generate two
different returns for two different customers based on how much they have
invested. They all should experience the same returns.
In fact, in the mutual fund world, this gets further streamlined in terms of
investment objectives, mandates, and other things. We will get to that in the
next chapter.
Anyway, now that the expectations are in place, it now boils down to logistic
arrangements on how this money gets managed.
To manage this money, you now ask your family members to transfer all the
money into one single account. The idea is to pool all the money in the same
account and use that to make investments in the market.
Since it’s all pooled into one account, that account holding the funds belongs
to all. Think of this as a rationale as to why ‘Mutual funds’ are called ‘Mutual’
Funds.
7.2 – The fund logistics
As a fund manager, it is your responsibility to ensure that those funds are
invested in the stock market, and it grows at a healthy rate. The selection of
zerodha.com/varsity
74
75
stocks is your prerogative, and you get to pick the stocks, choose for how long
to hold them and decide when to sell them. While you do this, you need to
ensure that every investor of yours is given the same treatment in terms of
wealth creation.
Remember, you are pooling all individual monies and investing it as a whole
aka a fund. So the return experienced by the investors should be uniform.
So given this, how do we ensure we have an equitable distribution of returns
across all the clients?
To do this, we can start by issuing shares against the investment made by
each investor. We can start by assigning a notional value to each of these
shares.
This notional value or the initial value can be anything, and you can assign
5,10,50, or even 100 as the starting value. It does not matter. The most
popular notional value if Rs.10, so we will stick to that.
We now issue Rs.10/- notional value shares to all our investors and estimate
the number of shares each investor holds. For example, the uncle has
invested Rs.65,000/-, so he gets –
= 65,000/10
= 6500 shares.
The table now looks like this –
zerodha.com/varsity
75
76
The total number of shares distributed across the five investors is 27,500,
which, when multiplied by the notional value, i.e. 10, gives us the total corpus
value, i.e. Rs.275,000/-.
Alright, now that the fund is formed and shares distributed across clients, the
fund manager gets to work on things he is best at, i.e. to pick stocks and
invest the money.
As a fund manager, you decide to invest the funds, i.e. Rs.275,000/- across ten
stocks. For the sake of simplicity, you choose to invest the same amount
across all the ten stocks. The distribution of funds in this manner is referred
to as the ‘equally distributed portfolio’.
The total corpus is Rs.275,000/-, so each stock gets an investment of
Rs.27,500/-.
The division of funds across the ten different stocks look like this –
zerodha.com/varsity
76
77
As you can see, the money invested across ten different stocks, each with
different share price, but the same investment goes to every stock, i.e.
Rs.27,500/-
At this stage, two things are in place –
The shares are issued to all investors. The number of shares is proportional to
the individual investment made
The funds are invested in the markets across ten different stocks
Now, once the funds are entirely invested in the market, the value of the
overall fund depends on how the shares perform daily. A few stocks can go
up, and a few can come down, resulting in either a profit or a loss. This profit
and loss should be passed to the investors. The quantum of profit or loss
experienced by the investors is directly dependent on the amount of money
each investor has invested in the fund.
Let’s continue the example to see how the P&L pass through happens. I’ve
randomly assigned percentage movement to all these stocks.
As you can see, the stock prices have changed on day 2, thereby the invested
value across each share also varies accordingly. As a result of this change, the
zerodha.com/varsity
77
78
total value of the portfolio is Rs.277,844. The fund has generated a one day
return of Rs.2,844/- or 1.0340%.
The profit of Rs.2,844/- has to be distributed across all the five investors in
proportion to their investments. To ensure a fair distribution, all we need to
do is, ensure the notional value goes up (or down) by the same percentage as
the fund, which is 1.0340% in this case.
Initial notional value (day 1) – 10
P&L % in funds – 1.0340%
New notional value (day 2) – 10 *(1+1.0340%) = 10.1034
So, the new notional value is 10.1034, multiplying this with the number of
shares should result in the new investment value for the investor.
As you can see, the investment for each of the investors has gone up by the
same percentage point, but the absolute money made by them differs, based
on the initial investment amount.
Also, if you add up all the new investment amount, you will get the new fund
value, i.e. Rs.277,844/-.
Before we wind up this chapter, I want you to remember these points in the
context of a mutual fund –
zerodha.com/varsity
78
79
An investment fund is formed when different people pool in their money
The investment objective remains the same across all the investors
Notional value is assigned at the start of the fund formation, which then
fluctuates based on the daily investment value. In the Mutual fund world, this
is called the ‘ Net Asset Value ’.
A mutual fund’s net asset value or NAV is one of the most important metrics.
On an end of day basis, the mutual fund company does the following
calculations –
The value of all the investments
Expenses of running the mutual fund
Based on these two parameters, the NAV of a fund is estimated daily. The
formula to calculate the NAV is –
NAV = (Value of all the assets – the expenses)/number of shares (units)
I’ll end this chapter here. I’ll be happy if you have fully understood the
concept of what a fund is and the role NAV plays.
We are still in the early stage of the learning curve, and we will revisit these
topics. However, before I wind up this chapter, I have a question for you
related to the example we used in this chapter. 
On day 3, suppose your father in law approaches you and wants to invest
Rs.75,000/-, at what rate will you issue the shares to him?
Would it be Rs.10 (initial value) or Rs.10.1034/-?
zerodha.com/varsity
79
80
Key takeaways from this chapter
● In a mutual fund, different people invest in a collective
investment vehicle with a common investment objective
● Every investor in a mutual fund is treated equally in terms of
percentage return
● At the start of the fund activity, every investor is issued
shares/units at a notional value
● The value of the shares/units change based on how invested
assets perform daily
zerodha.com/varsity
80
81
CHAPTER 8
The mutual fund fact-sheet
8.1 – The Mutual Fund world
In the previous chapter, we set up a hypothetical situation that helped us
understand the concept of a fund and how it gets managed. We discussed the
idea of ‘pooling of funds’ to invest in the market with a common purpose. I
agree we oversimplified the previous chapter, but that’s ok as the objective at
this point is to understand the fund structure and the way it serves its
investors.
I also hope you are clear about the concept of ‘Net asset value or the NAV’.
The mutual fund NAV or the mutual fund unit is an elementary concept, and I
hope you have no confusion about this. If yes, I would urge you to read the
previous chapter once again.
We will, in this chapter, take that conversation forward and look at one of the
most crucial documents from a fund house, i.e. the Fund fact sheet. The
factsheet is a document that puts up all the information related to a
fund/scheme. By and large, everything that you need to know before
investing in a particular fund is available in the fund fact sheet. In this
chapter, we will look at fund factsheet and figure out how to read and
understand the same.
zerodha.com/varsity
81
82
Before we get to the fund’s fact sheet, I think it is essential to get a grip on
how wide and deep the Indian Mutual fund industry is. The discussion will
help you understand the length and breadth of the mutual fund industry –
So here are necessary details for you (as on Dec 2019) –
The number of fund houses – 43 . These are the number of mutual fund
companies who have obtained the AMC license from SEBI. Example: Kotak
AMC, HDFC AMC, ICICI Pru AMC, Axis AMC, DSP etc.
The number of scheme – 2035 . Each fund house (AMC), can run multiple
schemes for people to invest. For example, ICICI Pru AMC runs 243 different
schemes, probably the highest in the industry. Franklin AMC runs about 67,
Aditya Birla AMC manages around 163 schemes. A scheme is a fund with a
specific investment objective, more about this when we dig into the
factsheet.
Money managed by AMCs – 26L Crore . This is the aggregate amount of
money managed by the entire mutual fund industry (across all AMCs). For
zerodha.com/varsity
82
83
example, HDFC AMC, which is one of the largest AMC, manages about 3.7L
Crs. Axis AMC, on the other hand, manages about 1.05L Crs. Yes AMC manages
about 916 Crs. This money is coming in from retail individuals and corporates.
Out of this 25.68L Crs, roughly 14.5L Cr is from retail investors like you and
me, and about 12L Crs is from the corporates
The number of unique Investors – 2 Crs Indians. This is the number of
individual investors investing in Mutual funds schemes across all the AMCs.
Again, these are good to know numbers to put things in some perspective.
You need not have to know these numbers if your objective is to invest in the
markets via mutual funds.
8.2 – The fund factsheet
An asset management company (AMC), manages and runs a mutual fund
scheme. An AMC can run many schemes as long as they have SEBI’s approval
for it. A mutual fund scheme is essentially a fund with a specific investment
objective. An investment objective is the stated goal of the fund. For example,
the investment objective of a mutual fund scheme could be an investment in
the top 100 large-cap companies in the country or it could be an investment
in the top 100 small-cap companies, so on and so forth. The investment
objective is stated at the inception of the fund, and the fund manager is
expected to stick to this mandate until the life of the fund.
So let us pick a fund fact sheet and dig into what information is available to
us. Let us start with Kotak AMC.
By the way, I’ve randomly selected Kotak AMC, please don’t consider this as a
recommendation of any sort
🙂
zerodha.com/varsity
83
84
I can go to AMC’s website to find the fund’s factsheet. Here is the snapshot of
the same –
As you can see, there are many different tabs right at the top – Equity, Tax
Saver, Hybrid, Debt, Liquid etc. These are all different categories of funds.
Over the next few chapters, we will understand what each of these categories
means and what to expect from investments made in these categories. For
now, let us stick to ‘Equity’ as a category. As you can see, there are many
different funds/schemes under Equity as a category. Let us pick ‘Kotak Small
Cap Fund’ and see what goes in the fact sheet. Click on the link, and you will
find the fund’s factsheet. In Kotak’s case, they call this the ‘One Pager’. Fair
enough.
SEBI has mandated that the name of the fund should be indicative of what
the fund is like to do. So moment I read, ‘Kotak Small Cap Fund’, I know that
this is a fund which focuses on small-cap investments.
I’ve downloaded the fund’s one-pager, and here is the very first page –
zerodha.com/varsity
84
85
The introductory paragraph gives us information on the stated objective of
the fund. As you can see, the stated objective says ‘Kotak Small Cap generates
capital appreciation from a diversified portfolio of equity & equity-related
securities by investing predominantly in the small market capitalisation
companies across sectors’
From this, we can infer –
1. The fund manager intends to have a diversified portfolio; therefore it is
not focused on a specific sector
2. Investments are in Equity and equity-related securities. This is mainly
stocks
zerodha.com/varsity
85
86
3. Investments are predominantly in the small market capitalisation
companies, which means as the fund name suggests, they look at
investments in the small-cap company
4. The second section talks a bit about how they intend to research these
small-cap stocks. Frankly, this should not be of concern to you. I mean think
about it – if you knew what to look for when investing in a stock or if you had
an opinion on what makes a good stock, then you are better off investing in
the stocks directly right? Why mutual funds at all?
But since the information is any way out there, here is a sneak peek into their
research methodology –
Look at the integrity of the promoters – necessarily ensure they are not
scammy
Ability to generate cashflow – meaning they look for companies that are
operationally profitable and capable of producing a surplus over all the
expenses
Experience of market cycles – ensure that the company has survived
through the test of times and has proved its resilience
Simple business model – No complicated verticals and easy to understand
companies
Quality metrics – This means that all the financial ratios tick right
Business quality – Good quality business I guess J
Low leverage – Companies with very little or zero debt
Now, I can decipher this because I belong to the same industry. However,
most of the investors cannot read through these terms, and frankly, as I
mentioned earlier, you don’t have to worry about this.
zerodha.com/varsity
86
87
8.3 – Other fund facts
The fund fact sheet presents a lot more interesting data points. We will also
use this opportunity to understand some of the key jargons used in the
mutual fund world. Here is the snapshot for the fund’s other facts –
The initial section is the investment objective, which we reviewed earlier, so
we will skip this section. The next thing you can notice is the benchmark of
the fund. A mutual fund scheme should essentially benchmark itself to an
index. This is required to evaluate the performance of the fund over a period.
A mutual fund should have the appropriate benchmark. For example, a
small-cap fund is benchmarked against a small-cap index, as in this case. It is
almost mis-spelling if the benchmark is not appropriate, for example, a
small-cap fund being benchmarked against a large-cap index. To put this
context, the performance of a family car such as Wagon R should
zerodha.com/varsity
87
88
benchmarked against another family car such as maybe a Swi, and it would
be futile to benchmark it against a Ferrari.
The next section details the type of scheme; there are a couple of exciting
things to note here. The type is– Open-ended, equity, growth scheme. There
are three critical parameters here; let us understand what it means.
Open-ended – When an AMC starts a fund, they have the option to let that
fund run for either a fixed period or keep it going forever. For example, I can
start a fund today and let it run for three years from today, at the end of 3
rd
year, the fund will cease to exist, and the investor is obligated to collect his
money back (along with the profit or losses). Funds with such defined time
are called a ‘ closes ended fund ’. If a fund does not have an expiry date, then
it’s called an open-ended fund. For all practical purposes, its always good to
deal with an open-ended fund
Equity – This is a reference to the asset class the mutual fund invests. Equity,
as you know, refers to the shares listed in the market. Another asset class is
debt, which could be either corporate debt or PSU debt. More on this when
we deep dive into debt funds
Growth – Let us skip this for now. We will discuss this in a bit.
Apart from this, this section also details a few other things –
Fund Manager – I find this interesting to know who is managing the fund. I do
a quick google search to know his background and his past performance.
Aer all, he will be responsible for managing our hard-earned money, so it
makes sense to see a bit about his background
zerodha.com/varsity
88
89
Allotment date – This is the date from which the fund commenced its
operations. The allotment date gives you a sense of how old the fund is. It is
not that it matters, but the older the fund, slightly easy it gets to analyse vis a
viz a new fund.
The next section deals with ‘Plans & Options’. Under plans, there are two
variants –
Regular plan – This is interesting. Think about a farmer growing onions. He
nurtures the onion saplings, waters it, weeds it, and eventually harvests it
and gets the onion ready for consumption. Let us say the cost of the onion is
about Rs.30/- per Kg at this point. An intermediary now acts as an ‘agent’ and
delivers the onion to people like you and me, and we, in turn, pay him Rs.40/-
per Kg. The delta (Rs.10), is what the agent earns. Now replace the farmer
with the AMC, the onions with a fund/scheme, and the agent as a mutual fund
distributor. The mutual fund distributor is like the middleman between the
AMC and the investor. If a mutual fund distributor approaches you and sells
you a mutual fund, then he is selling you a ‘regular plan’, which means he is
entitled to receive a commission from the AMC for selling this fund to you.
There is nothing wrong with this, except that the money is going from your
pocket.
Direct plan – Now you don’t need to buy the fund via a distributor. If you
know which fund to buy, capable of doing your mutual fund research (which
by the way is the end objective of this module), then you can buy that fund
directly from the AMC. When you buy directly from the AMC, then there is no
distributor involved; hence the distributor commissions are not paid, which
zerodha.com/varsity
89
90
means you save on commissions, which naturally means a better return on
your investment.
Just to let you know, when you buy mutual funds via Zerodha, you are buying
a direct plan; hence you will enjoy a better return. We will deep dive into this
topic later in this module, but for now, remember when you invest in mutual
funds, opt for a direct plan as you will save on commissions and therefore
enjoy the better return.
The other bit in this section is about the option. As you can see, this fund has
two options –
Dividend payout – Think about it, when you buy a stock of a company and
the company issues a dividend, then as an investor, you are entitled to
receive these dividends right? Likewise, when the fund manager buys the
stock of a company, and the company issues a dividend, then the AMC
receives this divided. Since the funds with the AMC belongs to the investors,
this dividend belongs to the investors. The dividend you are entitled to obtain
from the AMC is to the extent you’ve invested in the fund. The AMC gives you
two options – you can withdraw this dividend, or you can choose to reinvest
the dividend amount and buy more units of the fund. The dividend payout
option helps you withdraw the dividend as and when the dividend gets paid.
There are technicalities here as to how the AMCs issue dividends. We will
discuss this at a later point.
Dividend reinvestment plan – This plan receives the dividend on your behalf
and reinvests the dividend into the same fund. So necessarily, you don’t get
the dividend in the form of cash, but instead more units or NAV of the same
fund.
zerodha.com/varsity
90
91
Growth plan – In the growth plan, the investor does not receive any
dividends. The profits earned are ploughed back to fund and therefore the
‘compounding effect’, works well here. I personally prefer this plan over the
other two.
Next up is the SIP details. SIP stands for ‘systematic investment plan’. In a
typical SIP, you will invest the same amount of money every month for as
many years as possible. Example of a SIP is investing say Rs.5000/- in Kotak
Small-cap fund on 5
th
of every month for as many months as possible. Think
of SIP as investing in instalments. SIP is perhaps one of the most significant
financial inventions and has many merits to it. Given the importance of this
topic, I think a separate chapter on this topic is justified, and we will do that
at a later point. For now, think of SIP in its basic form, i.e. to invest a fixed
amount of money every month in the same fund for many years.
As you can see, you can SIP on Kotak Small-cap fund, but for that, the AMC
has specified that the minimum SIP amount every month is Rs.1000/- and the
minimum number of months is six.
The next section talks about the initial minimum investment in the fund. This
is self-explanatory, if you choose not to SIP, then the minimum amount to
invest is Rs.500/- and Rs.1000/- for the monthly SIP.
The last section of the fact sheet talks about the load structure of the fund.
There is a mention of few terms here like the SIP, STP, switches etc. We will
club all these in the SIP chapter. For now, let’s talk about the ‘load structure’.
The load structure is essentially the amount of money, in percentage terms;
you will have to pay in case you wish to withdraw from the fund. As you can
see, there are two types of load structure –
zerodha.com/varsity
91
92
Entry load – This is no longer applicable. However, years ago, you’d have to
pay a percentage for investing your money in a mutual fund. I guess AMC’s
have to mention ‘entry load’ as nil for legacy reasons.
Exit load – This is the amount of money you will have to pay at the time of
withdrawal. As you can see, there is a 1% load if you wish to withdraw before
the completion of 1 year and no-load post that.
8.4 – Riskometer
Every AMC is supposed to self-asses the riskiness of the fund and lets the
customers know about this. The self-assessment is something that SEBI
mandates to avoid cases of the misspelling of the financial product. For
example, a small-cap fund should not be packaged as a low-risk fund and
sold to the investors.
Here is how the AMC does a self-assessment of risk –
The needle of the riskometer points to ‘moderately high’, meaning that the
Kotak Smallcap fund is risky. The text next to the riskometer reiterates this.
Now, agreed this is a risky fund, but that should not stop you from investing
in risky funds.
Remember, the antidote for ‘risk’ in the mutual fund world is ‘time’; hence the
longer you stay invested in a mutual fund, the safer it gets.
zerodha.com/varsity
92
93
More on this in the next few chapters, so stay tuned.
Key takeaways from this chapter
● The factsheet of a mutual fund details all the essential
parameters worth knowing about the mutual fund
● The investment objective of a fund is essentially the guiding
principle for the investment the fund manager makes
● Open-ended funds don’t have an ‘expiry’ for the fund. It can go
on forever
● Close-ended funds are time-bound
● Regular plans pay out distributor commissions, hence lower
yield to investors
● The direct plan does not pay distributor commissions; hence
the returns are higher for the investor
● The MF investor can choose to receive or reinvest the
dividends
● Riskometer is a self-assessment of risk by the AMC
zerodha.com/varsity
93
94
CHAPTER 9
The Equity scheme (Part 1)
9.1 – October 2017
The previous chapter hopefully has given you some insights into reading a
mutual fund factsheet. The factsheet lists some of the good to know
information about a mutual fund. Do remember, the factsheet also doubles
up as a marketing document for the Asset Management Company (AMC),
hence read through the fund’s factsheet with a pinch of salt.
Starting from this chapter, we will shi our focus on the mutual fund
categories. The idea is to discuss the main categories and a few subcategories
of mutual funds.
Please note, the term ‘subcategory’ in the context of mutual fund categories
does not exist, but I think it makes life simpler if you thought about the
mutual fund categories this way.
I’m not sure if we can cover all the subcategories in this module. For example,
Debt fund as a main mutual fund category has nearly 16 different
subcategories, equity as a category has about 10/11 subcategories. Given
this, as you can imagine, discussing the entire gamut of MF categories will
digress us from the central theme of this module which is personal finance.
The idea here is to lay down a foundation for you to understand the main
mutual fund category (and a few subcategories) and hopefully, this
zerodha.com/varsity
94
95
foundation will help you understand the many subcategories of mutual fund
schemes.
No discussion on the mutual fund universe is complete without touching
upon the SEBI’s October 2017 circular on MF categorisation. This circular from
SEBI was fairly significant, and it helped simplify the MF universe. To
appreciate why this SEBI circular is essential, we need to dig up a bit of
history.
Back in the days, the mutual fund world was a bit chaotic. The asset
management companies would float many different schemes with
overlapping investment ideologies. These funds would oen confuse or
mislead investors. For example, an AMC would run a ‘large-cap fund’, which
by definition should predominantly have only large-cap stock, but these
AMCs would stuff in small-cap stocks, which as you can imagine bumps up
the volatility (and the return) of the fund. A typical large-cap investor would
sign up for the market returns plus lower volatility, but the presence of
small-cap stocks in a large-cap fund kind of defeats the purpose.
Here are a bunch of other problems that existed pre-Oct 2017; these
problems existed mainly due to the lack of proper mutual fund classifications
and definitions.
Multiple funds – An AMC would launch numerous funds with similar
investment objectives. For instance, it was common for an AMC to have
multiple large-cap or mid-cap schemes, while all these funds had the same
investment objective. The distinction between the funds was not too clear.
Lack of definition – While an AMC would title their scheme as a large or
mid-cap fund, it would contain stocks from other market capitalisation. The
zerodha.com/varsity
95
96
problem occurred because there was no formal definition of market
capitalisation.
Portfolio composition – The mutual fund schemes lacked a clear definition
in terms of portfolio composition. For instance, the portfolio of a mid-cap
fund is expected to hold mid-cap stocks, but it was common to find funds
with a large proportion of small-cap stocks while the name of the fund
suggested the fund was a mid-cap focused fund.
These problems led to a series of other issues. One of the major concerns was
with benchmarking of funds. A large-cap fund is benchmarked against a Niy
50 index; now we have a problem if a fund with small-cap stocks gets
disguised as a large-cap fund and gets benchmarked against a large-cap
index. The performance of such a ‘large-cap fund’ (at least in bull markets) is
bound to get skewed and offers an abnormal positive return, oen
misleading the investor.
SEBI addressed these problems with the Oct 2017 circular. You can find the
original circular here.
The circular clearly defined the market capitalisation of stock, which naturally
solved a few legacy issues in the mutual fund world. As per the definition –
Large-cap stocks – 1
st
to 100
th
company in terms of full market capitalisation
Mid-cap stocks - 101
st
to 250
th
company in terms of full market capitalisation
Small-cap stocks – 250
th
company onwards in terms of full market
capitalisation
With this formal definition, there was no longer ambiguity on the market
capitalization, and the AMCs were now forced to comply with the definitions.
zerodha.com/varsity
96
97
Further, SEBI mandated that an AMC can have only one scheme in any
category (except for the thematic, index fund, and fund of funds). This
mandate put a stop to AMCs offering a bouquet of schemes with an
overlapping investment thesis. To make things clear, SEBI defined the
portfolio composition as well. To put this context, post the circular, if an AMC
were to run a large-cap fund, then SEBI not only defined what large-cap is but
also set the minimum number of large-cap stocks (in % terms) the fund
should hold in its portfolio.
Anyway, let us jump to the different mutual fund categories and
subcategories and start exploring them. The idea here is to understand these
categories and invest in them based on our financial situation in life.
9.2 – The Mutual fund universe
Primarily, there are five different categories of mutual funds under which
there are many different categories. Think of them as a ‘category –
subcategory’ way of classification. Here are the main categories –
zerodha.com/varsity
97
98
1. Equity
2. Debt
3. Hybrid
4. Solution-oriented
5. Other schemes
The entire ‘category – subcategory’ structure is as follows –
To begin with, we will focus on Equity as a category. As per SEBI’s circular, an
AMC is supposed to run only one scheme per category. For example, an AMC
can have only one large-cap, one mid-cap, one small-cap so and so forth.
However, under Equity, an AMC can have multiple sectoral funds.
9.3 – Equity Category
The equity category is perhaps the most popular MF category in terms of
retail participation. As the name suggests, the schemes under the equity
category invest in listed company shares. As you are aware, there are many
different styles of investment in the market. A few of these popular styles
have been picked and formally inducted into the ‘Equity category’. As you can
see from the image above, here are nearly 11 different subcategories within
zerodha.com/varsity
98
99
the Equity category. Each of these categories is a different style of investing in
the market, and they all differ in their risk and reward characteristics.
However, the general philosophy of investing in an equity scheme remains
the same, i.e. to generate wealth. What differs across these categories is
essentially the timeline of this wealth generation and like I mentioned, the
risk and reward.
Over the years, thanks to my profession, I’ve had the opportunity to interact
with many people about mutual fund investing. One thing that I can tell you
with confidence is that most of them approach mutual fund investing (at least
in the equity funds) with unrealistic expectations. Some even go to the extent
of looking at mutual funds as a proxy for direct stock investing. They almost
have a trading attitude with their funds. Such an approach to mutual fund
investing can have dangerous consequences for your capital.
Unless you have the right expectation and attitude towards equity investing,
it is nearly impossible to generate wealth from mutual fund investing. So
what is the right expectation/attitude when investing in an equity-oriented
mutual fund.
Well, the true answer to this question depends on the exact subcategory of
the mutual fund you are looking at. However, here are a few generic pitfalls to
avoid –
Not a short term solution – Equity oriented mutual funds are not a solution
for your short term financial goals. By short term, I mean 2-3 years kind of
time frame. Invest in equity-oriented funds only if you have the necessary
time it deserves. To put this in context, I started investing in an equity mutual
fund in 2006, it is the 14
th
year as of 2020, and I continue to invest in it. I’m not
zerodha.com/varsity
99
100
suggesting that you need to stay invested for this long a period, all I’m trying
to say is that you need to have a super long term approach to mutual funds.
I’d say at least ten plus years (my personal opinion). Anything lower than this
can be a futile attempt at wealth creation.
Why not short term? – One of the common follow up questions is why not
consider equity mutual fund for short term investments. Well, there have
been instances where short term mutual fund returns have swelled. It
requires a great amount of market study to figure and time this. Now, if you as
a common man investing in the market can time the market, then why invest
in mutual funds at all? You may as well invest in stocks directly, right?
Understand time – You may have heard of the saying, ‘time heals everything’.
Well, this is true for market volatility as well. The market is volatile; this is the
very nature of this beast. However, the only way for a common man to deal
with volatility is to give your investment sufficient time. Hence, a short term
approach to MF investing does not work.
Don’t keep switching – I’ve seen investors switch between mutual funds as
they would switch between their browsing tabs. Switching is essentially
redeeming the units from ‘Fund A’ to invest in ‘Fund B’, for no real reasons. In
my opinion, this cannot be packaged as long term investing. The true
definition of long term investing is staying invested in a fund across a
multi-year period (and across multiple market cycles). Of course, occasionally
there will be justifiable reasons for you to switch between funds, we will
identify these reasons at a later point.
Headline investing – Most investors get carried away by newspaper
headlines. A headline which remotely hints at ‘bearishness’, is taken way too
seriously and used as a reason to exit an ongoing mutual fund investments.
zerodha.com/varsity
100
101
I’m guilty of doing this mistake myself. Back in 2007, I pulled out of a fund
that was doing very well because I read a headline saying markets are likely
to go down shortly. The problem here is not just with the withdrawal; it is
actually with the fact that you are breaking an ongoing investment journey. I
was never able to restart this investment.
Trust me; you will do far better than most of the investing public if you
understand these basic points which make a big difference to your investing
journey. Here is how my investments in Mutual funds have done till date –
These are all regular funds. Unfortunately, the direct fund option was not
available back in the days. The returns would have been better, had I decided
to invest in the same fund, direct option. I’m in the process to transition all
my regular to direct funds. Hopefully, this table should look better over the
next decade
🙂
Also, I think three large-cap funds in my portfolio is an overkill, and perhaps I
should look at replacing at least two of these funds with a low-cost index
fund. At a later stage, I’ll share my thoughts on this topic related to asset
allocation and fund diversification.
We will now proceed to understand a few of these subcategories of equity
mutual funds.
9.4 – The Equity mutual fund subcategories
zerodha.com/varsity
101
102
Under the broad classification of equity funds, there are nearly ten
subcategories. As you may have noticed, the name of these subcategories is
quite descriptive and gives out a general idea about what to expect from such
a fund.
Large-cap fund – As the name suggests, a large-cap equity fund indicates
that the fund invests predominantly in large-cap stocks. These are the top
100 companies in India, with the largest market capitalisation. The
expectation is that these companies are also market leaders in the industry
they belong to. These companies are also supposed to be stable and safe.
Examples of large-cap stocks include companies like TCS, Reliance, Infosys,
HDFC Bank, etc.
Have a look at the portfolio of one of the large-cap mutual fund schemes.
This is the portfolio of Axis Bluechip fund –
As you can see, the portfolio predominantly contains large-cap stocks (80%),
invested in varying proportions. The weight assigned to each stock is the fund
manager’s prerogative. By the way, you may be interested to know that by
regulation, once a month, the AMC is supposed to disclose the portfolio
zerodha.com/varsity
102
103
details. So go to the AMC’s website and lookup for any fund you are interested
in, and you’ll find the portfolio details in the ‘statutory disclosure’, section.
Usually, when an investor decides to invest in a large-cap fund, he has a twin
agenda – (1) capital appreciation in line with the markets, (2) low volatility. By
low volatility here, I mean with respect to small and mid-cap funds.
In simple words, this means that the investor is looking at wealth creation but
with not so much risk to his capital. Do remember, these are large-cap stocks,
meant to be stable hence less volatile. Of course, by virtue of investing in the
stock market either directly or via a mutual fund, the capital is exposed to
volatility. Like I mentioned earlier, the only antidote to volatility is time. So it
goes without saying that you need to stay invested for a long period to factor
in the volatility and generate decent returns.
Here is a look at how the top large-cap mutual funds have performed over the
last ten years. I’ve defined ‘top’, by considering the size of the fund’s AUM. I’ve
taken this data from Moneycontrol –
The key point to note here is the positive return across all the funds against a
long investment horizon.
zerodha.com/varsity
103
104
Mid-cap/small cap/large & midcap funds – I guess the names are quite clear
for us to know what to expect from the fund.
The mid-cap fund predominantly consists of mid-cap stocks and the
small-cap funds contain small-cap companies. The volatility in mid and
small-cap stocks is quite high. Like the large-cap stocks, investment in these
funds should be long term. You cannot afford to invest on a short term basis
in these funds. For example, here is how the small and mid-cap funds have
performed over the last two years –
The last two years have been particularly bad for the small and mid-cap
stocks, and this is evident across the fund’s returns. I’m not trying to say that
the returns across all two years or three years (or any short term cycle) will
always be bad. It depends on the market; however, for a common man, it is
nearly impossible to time the market and calls the cycles. Hence when we
invest, we should have a long term agenda, or at least have the intent to stay
invested for the long term.
Here is how some of these small and mid-caps have performed over the last
ten years –
zerodha.com/varsity
104
105
All the funds have delivered a fairly decent positive return. Also, notice the
ten-year performance of small and mid-cap funds are better than the
large-cap funds; this should be evident to you because small and mid-cap
funds are more volatile compared to large-cap funds.
The intent behind investing in either of these funds is the same as large-cap
i.e. wealth creation over a long period. However, you expect a return much
higher than a large-cap fund (against much higher volatility). This is obvious
because the fund contains companies which have a long headroom for
growth. As the company grows, so would the returns.
The large and mid-cap fund is a cocktail of both mid and large-cap stocks.
Unlike an exclusive large/mid/small-cap fund, the ‘large & mid’ cap fund is
expected to have 35% of its investment in large-cap and another 35% in
mid-cap stocks. For example, this DSP large and mid-cap fund has stocks like
Infosys, Airtel, HDFC Bank, and also, stocks like Hexaware, Hatsun Agro, and V
Guard. Technically the fund can be a 65% large (or mid) and 35% mid (or
large) cap stocks. The extent of the skew depends on the fund manager.
Since the large and mid-cap fund is a mixed bag, the expectation on the
return front is slightly higher than a regular large-cap fund but lower than a
small-cap fund. The risk is higher than a large-cap fund but lower compared
to mid or small-cap fund. Here is how the returns for small and mid-cap stack
up for the last ten years –
zerodha.com/varsity
105
106
By the way, given that there are so many AMCs and therefore so many
different funds for the same category, how would one narrow down on a
single fund to invest in? Well, this is a different topic altogether, and it
involves looking at various parameters on risk, returns, performance, and
costs. We will take this up aer we finish all our discussions on MF categories.
In the next chapter, we will discuss the remaining few Equity subcategories
and then move to debt.
zerodha.com/varsity
106
107
Key takeaways from this chapter
● Large-cap stocks – 1
st
to 100
th
company in terms of full market
capitalization
● Mid-cap stocks – 101
st
to 250
th
company in terms of full market
capitalization
● Small-cap stocks – 250
th
company onwards in terms of full
market capitalisation
● Large-cap funds should contain at least 80% in large-cap
stocks. Large-cap funds are expected to have lower volatility
and steady returns
● Mid-cap and small-cap funds have higher volatility and return
expectation compared to the large-cap funds
● Mid and large-cap stocks contain at least 35% each of mid and
large-cap stocks.
zerodha.com/varsity
107
108
CHAPTER 10
Equity Scheme (Part 2)
10.1 – Multicap funds
We discussed the equity scheme and a few of its subcategories in the
previous chapter. We will take that discussion forward in this chapter.
Next up is the multi-cap funds. As the name implies, a multi-cap fund is not
bound to particular market capitalization. The fund manager is free to pick
stocks from the entire market and create a diversified portfolio (the
diversification is mainly in terms of market capitalization). In a sense, the
fund manager is chasing opportunities that he thinks make sense. The only
mandate for a multi-cap fund is that it should consist of 65% investments in
equity and related instruments.
Have a look at the portfolio of SBI’s Multicap fund –
zerodha.com/varsity
108
109
The portfolio contains large-cap stocks like HDFC Bank Ltd to a relatively
small company like UFO Moviez Ltd. Of course, the investments in these
stocks are of varying degrees; this is the Fund manager’s call. The portfolio
mix in terms of capitalization is also dependent on the fund manager. The
portfolio mix for SBI multi-cap fund looks like this –
zerodha.com/varsity
109
110
Now, given the fact that the fund is diversified across the different market
capitalization, the AMCs tend to benchmark multi-cap funds to the S&P BSE
500 index or the NSE 500 index. These indices are broad and contain the top
500 companies by market capitalization.
Given the fact that the multi-cap fund has a mix of market capitalization, the
return expectation is on the higher side. The higher return expectation is also
associated with a higher risk. Here is a summary of the returns from Multi cap
funds for 10 years –
zerodha.com/varsity
110
111
As you can see, the returns average about 10 – 11%, the lowest being 7.36%
and higher is around 16%.
This leads us to an interesting point. The AMC is an asset-gathering machine.
It tries to attract more and more funds to its schemes. Imagine, a multi-cap
fund does the asset gathering part very well and gathers a ton of assets. What
do you think will happen to this fund?
zerodha.com/varsity
111
112
Well, as the asset size grows, they will have to deploy this fund into stocks.
Unfortunately, in the Indian stock markets, the liquidity in the small-cap
space is not much, hence the fund is forced to invest the funds in large and
mid-cap funds.
Hence, as the asset base grows, a Multi cap fund tends to work like a large
and mid-cap fund. This probably explains why the SBI Multicap fund (8.5K
Crore in AUM) has nearly 70% of its investments in large-cap stocks.
The one thing you need to keep in mind when investing in a multi-cap fund is
the ‘fund manager’ risk. Since the fund invests in stocks across the spectrum,
the performance is largely dependent on the kind of stocks and the
proportion the fund manager decides to invest.
By the way, in my opinion, if you are completely new to mutual funds and
don’t know where to start and which category to pick, then I’d suggest you
start with a multi-cap fund. Think of this as going for a buffet dinner, where
you get a bit of everything.
10.2 – Focused Funds
We have discussed a few equity categories by now. I hope you’ve looked at
the fact sheet and portfolio composition of some of the funds. If you have,
then one thing that comes across quite evidently is the number of stocks in
the portfolio. It is very common for equity mutual funds to have a large
portfolio size (in terms of the number of stocks), the numbers average to
about 60-70 stocks in a typical equity portfolio.
The common theory is that the higher the number of stocks, the lower is your
risk (and of course the return).
zerodha.com/varsity
112
113
A focused fund does things differently. The focused funds, as the name
suggests, contains a maximum of 30 stocks in the portfolio, thereby creating a
concentrated portfolio. A concentrated portfolio is a portfolio with few stocks
(max 30 in this case), but each stock is picked only aer rigorous due
diligence. In the investment world, they call this high conviction bets. The
average number of stocks in focused funds is about 25 and if I’m not wrong,
JM Financials’s focused fund is perhaps the only fund with just about 11
stocks. They call this fund the core 11. Their portfolio looks like this –
Since the number of stocks is limited in a focused fund, the risk and return
profile of the focused fund changes drastically compared to other equity
mutual funds. As you can imagine, the focused funds offer the possibility of a
higher return along with higher risk.
Have a look at the return profile of the focused mutual fund –
zerodha.com/varsity
113
114
Over the last ten years, the returns range from 7.25% on the lower side to
16.75% on the higher side. These returns should give you a sense of how the
risk profile of the focused funds.
I like to think of a focused fund as a poor man’s ‘Portfolio Management
Services’, you get similar returns at a much lower cost and entry criteria.
This also leads me to the next point – the focused fund is not for someone
who is starting his or her mutual fund investment journey. I’m saying this
because the focused fund will be a lot more volatile compared to a diversified
mutual fund. I think it is very important to familiarize oneself with the volatile
nature of these investments and slowly ease up to the idea of market-linked
investments. If you start straight away with Focused funds, I’m afraid this
experience will be a bit harsh and may convince you to never look at MF as an
zerodha.com/varsity
114
115
investment option. I think a focused fund will be a great addition to the
mutual fund portfolio at a slightly mature state in the investment journey.
10.3 – Dividend yield funds
I wish there were a different name for this mutual fund category. The moment
you see ‘dividend yield’ as a part of the fund’s name, it is only natural to
expect that the mutual fund pays out regular dividends to its investors.
However, this is not true at all. A dividend yield fund (or for that matter any
other mutual fund) is under no obligation to pay out a dividend to its
investors.
Given this, why do you think a dividend yield fund is called a dividend yield
fund? Well, the name is representative of the strategy the fund follows. The
strategy as you can imagine involves investing in companies that payout
(high)` dividends regularly.
Dividend yield = Dividend paid during the year/ stock price
For example, if Infosys trading at Rs.780/- per share pays a dividend of Rs.22/-
for the year, then Infosys’s dividend yield is –
= 22/780
= 2.8%
Here is SEBI’s definition for this category –
zerodha.com/varsity
115
116
As you can see, the fund is predominantly invested i.e. at least 65% in
dividend-yielding stocks. There are two aspects to this –
The fund invests 65% of the corpus in dividend-yielding stocks; the balance
35% is open for other investments, which means that this portion (35%) may
be invested in non-dividend-yielding stocks
Ideally, these funds should invest in high dividend-yielding stocks. So one has
to define what ‘high dividend’ really means. The lack of clear definition leads
to inconsistencies in-stock selection. For example, a fund manager simply
states that high dividend yield is anything greater than 0.75% and another
fund manager may want to benchmark it against the indices dividend yield.
For example, check out the UTI Dividend yield fund –
They benchmark themselves to the Niy Dividend opportunity 50 indexes.
The fund’s portfolio, as you can imagine consists of companies which are well
established and consistent dividend-paying –
zerodha.com/varsity
116
117
The last ten-year performance of dividend yield funds are as follows –
As you can see, the performance is fairly standard across these funds.
I’m personally not a big fan of dividend yield fund simply because I prefer to
take that extra risk with growth stocks. Of course, the decision to invest or not
to invest depends on the portfolio goals of the individual.
zerodha.com/varsity
117
118
10.3 – ELSS Funds
The ‘Equity-linked Savings Scheme’ or the ELSS funds are a special category
of mutual funds that enjoy tax exemption on investments made under
section 80C of the Indian Income-tax Act, 1961.
As you may be aware, section 80C in the income tax act allows you to reduce
your tax burden by accommodating for certain investments and payments
made during the financial year, the reduction in the tax burden, however, is
up to Rs.1,50,000/- per year.
For example, if you have a total gross yearly income of Rs.1,200,000/- then
you can choose to invest Rs.1,50,000/- in various 80C options and reduce the
tax burden. If you do so, your taxable income reduces to 1,050,000/-.
Amongst the various investment options permitted under section 80C,
investments in ELSS mutual fund is one of them. You can choose to invest
either the entire permitted amount of Rs.1,50,000/- in ELSS or split this
amount across many different schemes such as Life Insurance, Public
Provident Fund, five year FD, Sukanya Smariddi Yojana, etc.
The decision to do so depends on your overall financial planning strategy. Of
course, we will discuss this more as we progress in this module.
Here is how SEBI describes an ELSS fund –
There are two important things to note here –
zerodha.com/varsity
118
119
ELSS funds have a mandatory lock-in of 3 years. I guess this the Government’s
way of inculcating long term investing behavior
🙂
ELSS funds have a mandate to invest 80% of the funds in equity and
equity-related instruments. There is no restriction on the market
capitalization of stocks.
Many people wrongly assume that ELSS funds are a proxy for a pure large-cap
fund but this is not entirely true. ELSS mutual fund, in general, can probably
be considered as a proxy for a multi-cap fund. The data below helps you
understand this –
zerodha.com/varsity
119
120
That’s the list of the 40 top ELSS funds and as you can see, 23 funds have less
than 70% in large-cap stocks and 17 of them have over 70% invested in
large-cap stocks. Some of the funds like the IDFC Tax Advantage Fund have a
fairly decent mix across all market capitalization, which makes it a clean
multi-cap fund.
Again, when you select an ELSS fund, the decision should depend on your
overall portfolio structure. For example, there is no point in having a
large-cap fund and again opting to invest in a fund like HDFC Taxsaver,
because HDFC Taxsaver has 83% invested in the large-cap stock.
The performance of ELSS funds for the last ten years is as follows –
zerodha.com/varsity
120
121
These are for a few of the top funds in terms of AUM. As you can see, the
returns average about 11-12%, which I think is in line with the multi-cap fund.
I think the last two chapters have laid down a brief introduction to equity
mutual funds. We will now proceed to understand the basics of debt funds
and cover as many subcategories as possible. Once we are through with this,
we will proceed to understand the techniques of selecting a mutual fund and
building a mutual fund portfolio.
All of this and more in the coming few chapters. So stay tuned for more
🙂
zerodha.com/varsity
121
122
The key takeaway from this chapter
● A multi-cap fund does not have any restrictions on where it
can invest. The manager invests in any stocks across market
caps (large, mid, and small) where he sees opportunities.
● One of the risks to watch out for in a multi-cap fund is the
‘fund manager risk.’
● A focused fund consists of not more than 30 stocks in its
portfolio. These are high conviction bets by the fund manager
● The risk and return of a focused fund is higher compared to
any other equity oriented fund
● A dividend yield fund does not mean the fund pays regular
dividends to its investors
● The dividend yield fund invests in high dividend-yielding
stocks
● ELSS funds are tax saving funds under section 80C of the
Indian Income Tax act 1961
● A maximum investment of 1,50,000/- is permitted under
● An ELSS fund is considered a proxy for a multi-cap fund
zerodha.com/varsity
122
123
CHAPTER 11
The Debt Funds (Part 1)
11.1 – The origins of debt
Over the next couple of chapters, we will cover the basics of debt
mutual funds. As you may recollect from the earlier chapters, there
are about 16 debt mutual fund categories. I don’t intend to discuss
all these categories of a mutual fund, because a typical investor
does not need these many categories of debt investment. Instead,
I’ll discuss the following which I think are essential –
1. Liquid funds
2. Overnight funds
3. Ultrashort term funds
4. Medium duration
5. Dynamic bonds
6. Corporate bond
7. Credit Risk
8. Banking & PSU
9. GILT funds 2 different types)
In my opinion, this is a fairly exhaustive list and will cover many
different investment situations which may arise. However, if you
would like to know more about a category which isn’t discussed
here, then please do post a comment and I’ll be happy to give you
clarifications in the comment section.
zerodha.com/varsity
123
124
The debt-oriented, liquid, and overnight funds together constitute
nearly 50% of the 27 lakh crore assets under management AUM in
the mutual fund industry (as of Jan 2020. So as you can imagine,
this is a relatively large chunk of investor money. The debt funds
play an essential role in the investor’s portfolio, and it serves a
variety of purposes, including capital protection.
Before we understand how and when to use a debt fund, we need
to understand a more fundamental concept, i.e. the origin of debt.
To help you understand this, I’ll take the example of a simple debt
structure, which I guess we all would have come across directly or
indirectly in our daily lives.
So let’s get started. Assume you want to buy an apartment.
You do your research and shop around for the apartment with a
checklist. After an exhaustive search, you eventually circle in on
your dream apartment. The apartment comes with everything that
you ever wanted – swimming pool, clubhouse, convention centre,
zerodha.com/varsity
124
125
supermarket, tennis court, and everything else desirable. The
apartment costs you a sweet 1.5Cr, all-inclusive. You have 40L
stashed away in your bank, which suffices as the down payment.
You still need 1.1Cr to fund the property purchase. How will you
source the additional fund?
Chances are, you will approach a bank and request for a loan. The
bank evaluates your request and either give you a loan or denies
the loan. Needless to say, before deciding to provide you with a
loan, the bank will do a ton of background work and dig up every bit
of information about you. One of the critical inputs for the bank is
your credit score issued by agencies such as CIBIL or Experian. The
credit score is a reflection of your creditworthiness, higher the
rating the better it is for you and of course, a low credit score
implies no loan or a loan at an exorbitant interest rate.
So let us just assume that you have a fantastic credit score and the
bank decides to give you a loan of 1.1Cr against your apartment
purchase. The details of your loan are as follows –
Credit score: 850
Amount : Rs.1,10,00,000/-
Tenure: 10 years or 120 months
Interest rate: 8.5%
Total interest payable : Rs.53,66,129/-
Total payable Int + Principal) : Rs.1,63,66,129/-
Monthly EMI Rs.1,36, 384/-
zerodha.com/varsity
125
126
There are plenty of online calculators you can use to get these
details. I’ve used the one available on Bajaj Finserv site. Of course,
the credit score is arbitrary here
🙂
These details, along with a bunch of terms and conditions are
printed on a document. A stamp paper is attached with stamp duty
paid, and the document is registered. Finally, both the parties sign
off. A document such as this is called a loan agreement.
Finally, the loan amount is credited from the bank to your bank
account. The apartment will remain hypothecated to the bank till
the entire loan amount is repaid. The hypothecation works as
backup security for the bank. In case you refuse to repay the loan,
the bank can sell your apartment and make good their principal and
interest.
From the bank’s perspective, the loan is a ‘collateralised loan’,
because the loan is secured against collateral, i.e. the property in
this case. A collateralised loan is a safer bet for the bank as
opposed to a non-collateralised loan.
At this point, I want you to recognise how a debt obligation is
created. A debt obligation is created when a person needs to carry
out an economic activity for which the fund requirement is far
higher than what is available to him.
Going back to the apartment case, assuming things go smoothly, on
every month, for the next ten years the borrower is expected to pay
back a sum of, i.e. Rs.1,36, 384/- to the bank. The regular inflow to
the bank is the ‘cash flow’.
zerodha.com/varsity
126
127
So far, so good, this is a reasonably simple debt structure to understand. Let us now shift focus on
the risk involved here. By risk, I mean the risk involved for the banker, i.e. the lender. What do you
think can give the lender sleepless night?
There are a couple of things that can go wrong –
Cashflow risk – The borrower can skip paying a couple of EMIs and
make irregular repayments. Irregular repayments mean that the
bank will take a hit on the expected cash flow, potentially leading to
a chain of undesirable events
Default risk – The borrower may get into an insolvent situation
wherein servicing the loan becomes very difficult; hence the
borrower decides not to repay. This is called ‘default’ or the ‘default
risk’.
Interest rate risk – The loan is given out at a specific interest rate.
However, the economic situation may change, and the interest rates
may drop in the future. This means that the bank will be forced to
reduce the rates, and hence the expected cash flow takes a hit.
Credit rating risk – The bank evaluates the borrower’s credit rating
at the time of giving out the loan. At this point, the borrower’s credit
rating could be excellent. However, for whatever reasons, the credit
rating of the borrower can suddenly degrade, thereby increasing
the chance of default risk.
Asset risk – In case the borrower defaults, the bank has the right to
sell the hypothecated property. What if the property itself loses its
value? This is a double whammy situation for the lender or the bank.
The bank loses both the principal and the asset.
zerodha.com/varsity
127
128
These are the most common risk associated with a debt obligation.
We have taken the example of a bank and an individual, the same
can be extended to corporates as well.
Imagine a manufacturing company wants to build a new plant. The
company needs about INR 800 Crores to commission this plant.
How can they raise this money? There are two ways the company
can raise this money –
Approach a bank and seak a loan, pretty much like the apartment
case we discussed
Instead of a bank, the company can choose to raise a smaller
amount of money from several people (investors). Say in multiples
of 20Crs. The company, instead of paying interest to the bank, now
pays the interest amount to multiple investors.
If the company takes the 1stapproach and seeks a loan from the
bank, then the binding agreement is called the ‘loan agreement’. On
the other hand, if the company decides to raise this money from
multiple investors (multiple lenders), then the binding agreement is
called ‘ bond ’.
Think of a bond as a promissory note from the company to its
investors/lenders promising to repay the principal amount at the
end of the tenure and a periodic interest amount, also called a
coupon.
I agree this is a rather crude and unconventional way to introduce
the concept of ‘bond’ to you, but I hope you get the point. A bond is
a debt product wherein the lender with surplus capital provides
capital to the borrower who requires the capital. In exchange for the
zerodha.com/varsity
128
129
money, the borrower promises to pay interest (coupon payments)
and repay the full principal at the end of the tenure.
As simple as that.
The risks that we discussed in the bank-apartment example applies
to bonds as well. Three risks matter the most when it comes to the
bonds –
Credit risk
Interest rate risk
Price risk
At this point, if you’ve managed to understand what a bond is, the
risk applicable (very briefly) then I suppose we are off to an
excellent start to learn more about the debt funds.
Remember this though – debt funds and the functioning of debt
funds is one thing and investing (or trading) the bond is another
thing. You as mutual fund investors should only be concerned about
three things –
When to invest in a debt fund and how to choose one?
What a particular category of debt fund does
The risk associated with that category of debt fund
The fund manager of the debt fund should be concerned about
investing or trading in the bond market.
The bond market is a reasonably big market, not just in India but
across the world. Companies often issue bonds to full fill their
zerodha.com/varsity
129
130
capital requirements and these bonds are subscribed by the
investors.
The mutual fund companies which have the capital subscribe to
bonds issued by the companies which have a capital requirement.
With this background, let’s start discussing the different categories
of debt funds.
11.2 – The liquid fund
The liquid fund is perhaps the most popular debt fund within the
debt fund universe. A liquid fund makes investments in debt
products which have a maximum maturity of up to 91 days.
In simple words, the liquid fund invests in debt obligations, wherein
the borrower promises to repay the borrowed money (principal)
within 91 days (maturity) of such borrowing.
Here is a typical example – Power Finance Corporation PFC of
India needs 150 Crs to fund its working capital requirement. They
agree to repay the borrowed amount to the lender within 50 days.
PFC agrees to pay 8.5% interest (also referred to as the coupon)
against this borrowing.
HDFC AMC has 150Cr to invest; they see this as an excellent
opportunity to earn 8.5% interest; hence they give the funds to PFC.
The deal is done.
After 50 days, PFC repays 150Cr to HDFC AMC along with 8.5%
interest.
zerodha.com/varsity
130
131
Note, when any interest or coupon rate is quoted, it is quoted on an
annual basis. So this is 8.5% for the 365 days. For 50 days, interest
on a pro-rata basis is –
= 50 * 8.5%/365
= 1.164%
So HDFC AMC will get back 150 Cr + 1.746Cr back from PFC.
I suppose this is a relatively simple deal to understand.
Like I mentioned earlier, a liquid fund by regulation can invest in
debt which has a maximum maturity of 91 days. When a corporate
entity borrows for such short term basis, they do so by issuing
something called as a ‘ commercial paper ’ or Cps. In the arbitrary
PFC example I used, PFC is deemed to have issued a 50 day CP,
which was subscribed by HDFC AMC.
The Government too borrows on a short term basis to fund its short
term financial needs. However, when the Government borrows, it
does not issue a CP but instead issues a treasury bill . The
Government has three variants of t-bills –
1. 91-day TBills, the maturity of 91 days
2. 182-day TBill, the maturity of 182 days
3. 365 day T-bills, the maturity of 365 days
You can read more about the treasury bills or the TBills here .
Now, place yourself as a lender, someone with surplus capital. You
are looking for an opportunity to invest 100 Crs. There are two
possible borrowers, both wanting 100Crs each –
zerodha.com/varsity
131
132
A sugar manufacturer willing to offer 6.5% coupon
The Govt of India provides a 6.5% coupon
Whom would you lend? This is a no brainer; you’d give to the Govt
because you know that with the Government, there is no credit risk.
The Govt will repay, but the same cannot be said about the sugar
manufacturer.
Does this mean that the sugar manufacturer will never get the
required funds? Yes, as long as the sugar manufacturer offers a
coupon equivalent to the Govt, it will be hard for them to source the
fund. The lender will lend if he is compensated for credit risk; hence
the coupon has to be higher than the equivalent T-bill.
So in this case, the sugar manufacturer should offer say 7 or 8%.
Let’s extend this thought. Assume there are two sugar
manufacturing companies –
Company A with an impeccable track record. It is in business for 25
years, profitable, and steady cash flows.
Company B, five years of operations, breaking even, backed by
young entrepreneurs.
Both need 100 Crs. Both offer 8%, you have the money, whom
would you lend?
Company A, of course, because company A has a better financial
history, hence lesser probability of default.
Does that mean, Company B will never get the funds? Of course,
they will, as long as they compensate the lender for the additional
credit risk. Hence company B has to offer something like 10 of 11%.
zerodha.com/varsity
132
133
The credit rating reveals the credit risk of a company. The credit
rating of the equivalent to an individual’s CIBIL score. The higher,
the better, which also means companies with higher credit rating
can borrow money by offering lower coupons.
In its portfolio, the liquid fund contains several CPs and T bills, while
T bills are relatively safer, CPs aren’t.
This leads me to the most critical point about liquid funds.
11.3 – Why liquid fund?
People invest in liquid funds to park cash, which they intend to use
sometime soon. By ‘sometime soon’, I mean within a year or at the
most within a year and a half. The purpose of this investment is to
protect the capital, use it in its entirety for the purpose planned. So
think about the liquid fund as a parking space for your excess
funds.
Question is – why to invest in a liquid fund and why not let it be in a
bank’s savings account. Well, people opt to invest in a liquid fund
because the liquid fund offers a slightly higher return compared to
the bank’s savings account.
The problem, however, is the fact that the liquid fund is often
pitched as a better than a savings account SA or the fixed deposit
FD’. This is not true at all. A liquid fund may offer higher than
SA/FD account, but also comes with a certain amount of risk.
zerodha.com/varsity
133
134
To put this in perspective, an average SB account rate as of today
Feb 2020 is 3.5% to 4% whereas the average Liquid fund gives
you a 6% return.
However, the liquid funds consist of several CPs, which are
suspectable to credit risk. Here is the snapshot of HDFC’s Liquid
funds –
As you can see, HDFC Liquid Funds has several CPs its portfolio. Of
course, the credit ratings of the issuer of these CPs are all good,
but then things change quickly in the markets. A downgrade in the
issuer’s credit rating means a steep cut in the NAV of the liquid
fund.
HDFC’s portfolio also has Government securities, which virtual
consists of no credit risk, thanks to the implicit sovereign guarantee.
zerodha.com/varsity
134
135
While this is a good liquid fund, it is still not risk-free, you can lose
your money if something were to go wrong, which is not the case
with a SA or FD.
To give you a perspective of how bad things can go, check this –
This is the NAV graph of Taurus AMC’s Liquid fund. The NAV fell
close to 7% on a single day in Feb 2017. All gains were wiped off,
and in fact, the investors took a hit on their investment capital. It
took almost a year for the fund to recover back to its previous
levels.
The reason for this fall was that Taurus had nearly 2000Cr of CPs
issued by Ballarpur Industries. The credit rating agencies
downgraded Ballarpur’s CPs, and that translated into a 7% vertical
fall in NAV.
zerodha.com/varsity
135
136
Anyway, I’d suggest you read this news article , and I think it puts all
the discussion we have had till now in some perspective.
So if you are investing in Liquid funds, you need to be aware of a
few things –
Invest only to park your spare cash
Expect a return slightly higher to your SA account
Liquid fund is not risk-free, you can lose money when you invest in
it
Choose a fund which has relatively less default risk – meaning the
liquid fund portfolio should have a higher concentration of
Government securities.
I’ll stop this chapter here. In the next chapter, I’ll discuss the close
cousin of the liquid fund, i.e. the ultra short term fund.
Stay tuned.
zerodha.com/varsity
136
137
Key takeaways from this chapter
● When a corporate entity borrows funds (for more than
one year), they do so by issuing bonds
● Corporate borrowings for less than a year is done via
the issuance of a commercial paper or the CPs
● When the Government borrows, they do so by issuing
a treasury bill or the TBill
● Against the borrowing, the borrower pays interest
(coupon) to the lender
● The lender faces multiple risks when lending funds to
the borrower
● Credit risk and interest rate risk is the primary risk for
the lender
● Liquid funds invest only in CPs and T bills with a
maximum maturity of 91 days
● Liquid fund is not a proxy for a savings bank account;
it carries credit risk.
zerodha.com/varsity
137
138
CHAPTER 12
The Debt Funds (Part 2)
12.1 – Overnight Fund
We are in living in strange times, as I write this, the market is down
nearly 30% from its peak. I’ve seen markets get hammered for a
variety of reasons – recessions, business cyclicality, fraud, political
unrest, civil unrest, geopolitical tensions, wars, and heck even
family feuds. But never in my wildest dreams could I imagine the
markets getting trashed owing to a virus of an unknown origin.
I guess with COVID 19, we have seen it all. At least, I hope so :).
Nevertheless, we have to do what we have to do. So let us get back
to the debt funds.
zerodha.com/varsity
138
139
In the previous chapter, we introduced the concept of a bond or a
debt structure and discussed the first debt mutual fund, i.e. the
liquid fund. Do recall; the liquid fund is not risk-free as most people
assume, it is susceptible to both default and credit rating risk. The
Taurus MF and Ballarpur example highlighted this credit risk in liquid
funds.
Both these risk types are significantly reduced (not eliminated) in an
overnight debt fund. Remember, a liquid fund invests in papers
maturing up to 91 days, this typically includes both the corporate
commercial papers and the Govt’s treasury bills.
An overnight fund, on the other hand, invests in securities which
have one-day maturity. Think of this as lending money to someone
for one day only. So at the start of the day, the Fund manager of an
overnight Fund lends to ‘someone’ which is recovered back in 24
hours.
This is precisely what happens in an ‘overnight debt mutual fund’.
Given the fact that the overnight fund invests (or lends) to 1-day
debt obligation, the chance of a change in credit rating risk is low.
The default risk still exists, although it is small.
The next obvious question is – who are these overnight fund lending
to? Well, the overnight loan happens to an RBI regulated money
market instrument called ‘Tri party Repo’ or the ‘TREPS’.
I’ll not get into the details of what a TREP is and its purpose, I think
that will stray us from the main focus of this chapter. All you need to
know is that a TREP is a relatively safe instrument wherein the act
zerodha.com/varsity
139
140
of lending and borrowing happens over a 24hr window. You can
read more about TREPs here – -
https://www.ccilindia.com/FAQ/Pages/TREPS.aspx#1
I want you to look at the portfolio of HDFC Overnight Fund –
As you can see, the entire portfolio consists of only one instrument,
i.e. the TREP. Have a look at the portfolio of the UTI’s overnight fund
–
Again, 100% of the fund invests in TREP only.
This leads us to an important conclusion – as every overnight fund
invests in TREP instrument, there is no difference between the
overnight fund A and overnight Fund B. They all tend to put up the
same performance. The only difference is because of the difference
in the expense ratio.
zerodha.com/varsity
140
141
Of course, we have not discussed the expense ratio, yet in this
module, we will in the coming chapter.
So who would want to invest in an overnight fund? Well, this is an
ideal fund for anyone looking at parking funds for a short term
duration. By short term, I mean for less than three months.
Remember, if you want to park funds for more than three months or
90 days, you are better off looking at a liquid fund.
It is futile to look at the return aspect of an overnight fund. It does
not make sense, because you don’t invest in an overnight fund to
chase ‘returns’, you do for the sake of convenience.
However, if you are interested, as of today, overnight funds yield
around 45% annualized. So you can do the math on a pro-rata
basis.
12.2 – Ultra-short duration Fund
Next up is the ultra short term debt mutual fund. Things in the debt
mutual fund start getting interesting from now.
Think of yourself as a debt mutual fund manager. Your job as a fund
manager is to find investments opportunities in the debt market.
You can do so by investing the scheme’s corpus in new bond/CP
issues, or you can choose to buy these bonds from the secondary
bond market.
Think of this as buying a stock at the IPO or buying it post the IPO
from the stock exchanges. Now, the moment you buy it from the
zerodha.com/varsity
141
142
secondary market, the price of the bond will (may) differ from the
first issue price.
Why would the price vary? Well, for a host of reasons including the
demand and supply dynamics of the bond.
Each time a bond is purchased, the bond manager expects a
periodic coupon (interest) payment during the tenure of the bond
and at the end of the tenure, the principal to be repaid.
Let us hold on to this thought for a moment. We will get back to this
thread in a bit.
Think of another case. Your best friend needs Rs.10,000/-. He
approaches you for it and promises to repay within a year. You
decide to give him this money, interest-free.
Now, how long does it take for you to recover back your money?
The time taken to get back your money is a year. It was easy to
evaluate the time taken because there is no other cash flow in the
form of interest repayment.
On the other hand, if there was an additional cash flow in terms of a
coupon payment, paid every three months, then what do you think
would be the time taken to recover the money?
While pinpointing to the exact number can be a bit tricky, intuition
says that the time taken to recover the money is little lower than a
full year, because there is cash flow. Do note; you can do some
math and get the exact time to recover the money, but let’s not get
there.
zerodha.com/varsity
142
143
The point to note is – in the presence of cash flow, the time to
recover the principal is lesser.
With this point, let’s go back to the previous thread.
Fund manager A subscribes to a bond at issuance. The
specifications are as follows –
Face value = Rs.1000
Coupon = 8%
Coupon payment frequency = Semi-annual
Maturity = 3 years
Question – How long will the fund manager A take to recover the
money invested in this bond?
Answer – Intuition says that it could be a little lesser than three
years.
Fund manager B buys the same bond from the secondary market.
Now, we know that the bond prices fluctuate in the market. Assume
the fund manager B pays Rs.1020 for the same bond.
Question – How long will the fund manager take to recover the
money invested in this bond?
Answer – Intuition says Fund manager B will take slightly higher
time to recover the price paid for the bond when compared to fund
manager A.
Fund manager C buys the same bond from the secondary market.
Assume the fund manager pays Rs.980 for the same bond.
zerodha.com/varsity
143
144
Question – How long will the fund manager take to recover the
money invested in this bond?
Answer – Intuition says Fund manager C will take lesser time to
recover the price paid for the bond when compared to Fund
manager A.
I’m trying to make two points here –
Bond price fluctuates
Based on the price paid, the time to recover the invested amount
varies.
There is an exact science to estimate the time to recover, that is an
integral part of the bond math. The metric, ‘time to recover’, is called
‘ Macaulay’s Duration of a Bond ’.
Why is ‘Macaulay Duration’ essential and why are we discussing
that? Well, have a look at how SEBI defines the characteristics of an
ultra-short duration fund –
According to this definition, an Ultra Short duration fund can invest
in short maturity bills and CPs, which has a maturity between 3
month and six months 90 to 180 days).
zerodha.com/varsity
144
145
An important point to note here is that SEBI specifies this at a
portfolio level and not restricted to an individual bill or CP. What this
means is that the fund can buy CPs with a maturity of fewer than
90 days or maybe more than 180 days, they can even invest in
TREPS, but at an overall portfolio level, the fund has to ensure that
the Macaulay duration of the entire portfolio falls within 3 to 6
months.
To give you a perspective, have a look at the portfolio of DSP’s
Ultra-short duration fund –
The bulk of the ultra-short duration fund is invested in money
market instruments; the maturity ranges anywhere between 1 day to
365 days. Mostly these are CPs belonging to various corporate
entities, here is a snapshot of their money market portfolio –
They also hold NCDs and Bonds NCDs and bonds are the same),
which have a maturity of at least a year –
zerodha.com/varsity
145
146
The job of the fund manager is to ensure that they not only manage
the returns but also manage the Macaulay duration of the entire
portfolio such that they adhere to the SEBI specified norm.
There is another interesting point to note here – while the ratings of
CPs kind of vary for the money market instruments, they are all
triple-A for Bonds and NCDs. Triple AAA ratings imply that the
probability of default is lower.
As the maturity of the bond increases, the bond manager is more
worried about possible default in the bond. Hence, they tend to
stick AAA rate bonds.
However, this leads us to a critical point concerning ultra-short
duration funds – they are not risk-free. These funds too, have the
risk of credit default and rating downgrade.
Given this, who should invest in an ultra-short duration fund?
I think that this is a good fund for anyone looking to park money for
12 years, plus they are ok to take a wee bit of risk on the parked
capital. If you can make peace with the fact that on the downside
your money can go down by a few percentage points, then go
ahead and park your funds in this ultra short term funds.
zerodha.com/varsity
146
147
If you are looking at parking money for lesser than a year, stick to a
liquid fund instead.
On the return side, I think it is reasonable to expect a return close to
the bank’s fixed deposit.
12.3 – Franklin and Vodafone saga
Since we are talking about Ultra-short duration bonds, I guess it
makes sense to quickly discuss the Franklin – Vodafone drama that
unfolded earlier this year.
Franklin India had invested in Vodafone India Limited VIL’s debt
papers across six different debt schemes, including its Ultra
short-duration bond fund.
In Oct 2019, the Supreme Court of India passed a judgement in
favour of the Dept of Telecom (Dot), in a case against DoT and the
telecom operators. As a result of the Supreme Court’s judgement,
the operators were asked to pay the licence fee and the spectrum
usage charge based on the Adjusted Gross Revenue AGR.
If you are not familiar with this, then I’d suggest you read this short
note from the good folks at Finshots, they have done a great job at
explaining the AGR episode
– https://finshots.in/archive/the-final-verdict-on-agr-2/
Anyway, to cut a long story short, post this judgement, VIL was now
expected to Rs.27,000 Crs to DoT towards unpaid dues.
This means VIL would be cash squeezed; hence they are likely to
default on their debt obligations.
zerodha.com/varsity
147
148
As a smart money manager, after all, sorts of ramification of this
judgement, Franklin India took a proactive step, and they themself
internally downgraded the VIL’s papers to junk status and wrote off
that investment.
To give you a perspective, Franklin India’s Ultra-short bond fund had
4.2% of its portfolio invested in VIL’s paper. Now, what do you think
happens when you 4.2% of your portfolio is rendered useless?
Obviously, the NAV of the fund falls. Check this –
In my view, Franklin may take at least a year or year and a half to
get back to the previous NAV levels. The only reason I’m discussing
the Franklin and Vodafone issue is to make you understand that
debt funds too are risky, invest in them only after you fully
understand the risk involved.
zerodha.com/varsity
148
149
I’ll stop this chapter at this stage. Before I wrap this up, I’d like to
give you a quick insight into the direction we are heading with this
module.
So far, we have discussed Equity mutual and few debt funds. The
discussion is restricted mainly to a brief introduction to these funds
and what happens within these funds. In the next chapter, we will
continue this and introduce a few other debt funds and probably
wind up the introduction bit.
Once we are through with that, we will start with the fund analysis
bit and figure how to select mutual funds, both debt and equity and
slowly steer our way in building a goal-based mutual fund portfolio.
So, we have a long way to go. Stay tuned and stay safe!
Key takeaways from this chapter
● Overnight funds invest in debt instruments with a 24hr
settlement cycle
● Almost all overnight funds invest in Tri party repo
● The performance across overnight funds is similar
● Macaulay Duration of a fund gives us a sense of how
long it takes for the fund to get back its invested
amount
● Ultra-short duration fund has a Macaulay duration
between 3 to 6 months
● Ultrashort duration funds are also risky
zerodha.com/varsity
149
150
CHAPTER 13
The Debt Funds (Part 3)
13.1 – Debt jargons
As we enter the 27th day of the nationwide lockdown, I hope you and your
loved ones are staying home, staying safe. The number of COVID19 cases in
India has crossed 17,000 with Maharashtra topping the charts with over 3,500
cases. I hope all of this ends soon and we can all get back to our normal lives,
until then the only mantra is ‘social distancing’, I hope you are following this
diligently.
I think many people across the country are using the lockdown opportunity
to learn something new and educated themselves. The traffic on Varsity has
shot up quite a bit, here is the pageview snapshot from Google Analytics –
Along with the pageview, the number of queries pouring in has also shot up.
We spend several hours every day to answer your questions.
zerodha.com/varsity
150
151
So if you find the new chapter update a bit slow, then please do understand
its because of the increased load
🙂
In the previous chapter, we introduced a term called ‘Macaulay Duration’. If
you recollect, Macaulay duration measure in years, the time required for the
bondholder to recover the price paid for the bond by the bond’s cash flow. We
did not discuss the math behind Macaulay duration because that’s outside
the scope, but as I hinted in the previous chapter, the next module is on fixed
income security (mini-series) where I’ll try and take this up in detail.
However, while we cruise along, there are few bond relationships that you
need to know –
The yield of a bond and the price of the bond are inversely proportional. If the
price of the bond increases, the yield of the bond decreases and vice versa
zerodha.com/varsity
151
152
Interest rates and bond price are inversely proportional. If the interest rates
increase, the bond price reduces and vice versa.
While we are at it, let me introduce another term – ‘ Modified Duration’, of the
bond.
The modified duration (measured in years) of a bond is essentially the
sensitivity of the bond’s price to the change in interest rate. So if a bond has a
modified duration of 3.2 years, then –
A 1% increase in interest rate decreases the bond’s price by 3.2%. A 1.5%
increase in the interest rate, lower the bond’s price by 4.8%
A 1% decrease in interest rate increases the bond’s price by 3.2%. A 1.5%
decrease in bond price, increases the bond’s price by 4.8%
We can generalize this – Higher duration funds have a higher sensitivity to
interest rate changes. So a 1% change in interest rate reduced the price of a
longer duration fund in a greater magnitude compared to a low duration fund
and vice versa.
In the context of a mutual debt fund, the modified duration is at an aggregate
portfolio level. In the example above, say for a 1.5% increase in the interest
rate, the debt fund’s NAV is likely to decrease by 4.8%. I hope you get the dri.
As a debt mutual fund investor, you are in the right spot if you are aware of
the few points we have discussed so far. Along with these few points, as a
bondholder or a debt mutual fund holder, you need to be aware that the
mutual fund you are holding is susceptible to –
zerodha.com/varsity
152
153
Credit risk – The risk that the bond held by the debt fund can get downgraded
Default risk – The risk that the bond issuer defaults on a coupon or principal
repayment
Of course, now you also know that the bond price has an interest rate risk,
but at this point, let us just assume the fund manager can hedge the interest
rate risk.
Anyway, we will get back to the good old debt mutual funds. In this chapter,
we will continue our discussion and take a few more debt (sub) categories.
We will start the conversation with the low duration, money market, and
short-duration funds.
13.2 – Low duration and Money Market
We looked at the ultra-short duration bond fund in the previous chapter. The
defining criterion for the ultra-short duration fund was the Macaulay duration
of the portfolio. As per SEBI’s classification, at the aggregate portfolio level,
the Macaulay duration of the ultra short term duration fund has to vary
between three to six months.
Next up is the low duration fund. The low duration fund is just like the
ultra-short duration, only that the low duration fund, the Macaulay duration
at the aggregate portfolio level varies between six to twelve months.
The credit risk of the low duration fund is similar to the ultra-short duration
fund. Hence it is imperative for the investors to glance through the asset
quality (paper quality) of the fund.
zerodha.com/varsity
153
154
Have a look at the portfolio of the IDFC AMC’s low duration fund –
As you can see, IDFC has 100% of its portfolio invested across various AAA
papers. However, just because the fund has only AAA papers, does not imply
zero credit risk. Remember, we discussed the Vodafone case in the previous
chapter.
While the credit risk exists, the interest rate risk for the low duration fund is
low. Have a look at the modified duration of IDFC’s Low duration fund
(published in the fund’s factsheet) –
The modified duration is 289 days. I can convert this to years by dividing this
by 360 –
= 289/360
zerodha.com/varsity
154
155
= 0.802
This means to say for every 1% increase or decrease in the interest rate, and
the NAV is likely to decrease/increase by 0.802%, which as you can imagine is
not much.
By the way, not all funds report modified duration in terms of the number of
days. Modified duration is expressed in terms of years.
For example, the Nippon India low duration fund expresses the modified
duration in years, which is 0.94 yrs.
zerodha.com/varsity
155
156
So when the fund expresses in years, you need not divide by 360. Instead, you
can use the number directly.
While we are at it, which of the two low duration funds do you think is risky in
terms of modified duration?
IDFC’s Low duration Fund with a modified duration of 0.802 or Nippon India’s
low duration fund with a modified duration of 0.94?
Here is a task for you – why do you think Nippon India’s low duration fund has
a higher modified duration? Can you look into their portfolio (as of April 2020)
and get your answer?
If you can answer these questions with ease, then we are headed on the right
track
🙂
Lastly, who should look at investing in a low duration fund? This is best suited
under situations where you want to park your money for a short duration and
utilize the funds towards a specific goal at a later point.
Next up is the money market fund.
The money market fund is somewhat similar to the low duration fund. Here is
SEBI’s classification of the money market fund –
As you can see, the maturity is capped to one year, similar to that of low
duration fund; the only difference is in terms of the portfolio constituents.
zerodha.com/varsity
156
157
A low duration fund can invest in both money market instruments and bonds
but ensure at the aggregate portfolio level the duration is between 6-12
months. The money market fund, however, can invest only in money market
instruments. The money market instruments usually consist –
‘Commercial Papers’ or CPs, issued by companies. CPs are unsecured
‘Certificate of Deposits’ or CDs. Banks issue CDs to entities depositing money
T-Bills, issued by the Government, carries a sovereign guarantee.
So just to summarize, the fund manager of a low duration fund can invest in
CPs, CDs, and perhaps even in a bond with two years maturity. However, a
money market fund manager can only invest in CDs and CPs.
Let me ask you two question –
What is the risk of investing in a money market fund?
What do you think will be the modified duration of a money market fund? Will
it be 1, greater than one or less than 1.
Do pause here, think about it, try to answer yourself.
Have a look at the factsheet of UTI’s Money market fund –
zerodha.com/varsity
157
158
You will find the answers for both the questions here.
The money market fund is exposed to credit risk. As you can see, 9.39% of the
portfolio is invested in a single company’s CP or CD. Of course, the company’s
paper enjoys a high rating, but I want you to remember the fact that these
ratings can change. So yeah, credit risk exists in a money market fund.
As you may have guessed, the modified duration will be under one year for a
money market fund, which implies that the interest rate risk for these funds is
low.
Investment philosophy in the money market fund is similar to the low
duration fund. In fact, many investors oen choose between low duration and
the money market fund.
zerodha.com/varsity
158
159
13.3 – Short Duration and Medium Duration funds
Next up is the short duration fund. Let’s start straight with SEBI’s definition –
The Macaulay’s duration of the short duration fund has to range between 1
and 3 years. Aer reading the SEBI definition, what is the first thing that
comes to your mind?
Well, I hope you think about it from a risk perspective. With an increase in the
duration, the modified duration also increases – which means the risk
associated with changes in interest rate is higher with a short duration fund
(and the medium duration fund). Do note; this was not so much of a concern
with the low duration and money market fund (or even the ultra-short
duration fund).
Of course, credit risk continues for short duration fund as well. Have a look at
the rating profile of the Mirae Asset Short Term Fund –
zerodha.com/varsity
159
160
As you can see, the fund has a mix of AAA, AA and A1+ debt papers in the
portfolio. For the same fund, look at the modified duration –
The modified duration is 2.67 years, which means, for every 1% increase in
the interest rate, the fund will drop 2.67% in its NAV. The risk associated with
the short-term fund is higher compared to all the other funds we have
discussed so far.
Also, do notice the Macaulay duration of the fund, it is below 3, as SEBI has
defined.
With a considerable amount of risk, you need to be clear with your
investment objective in these funds. Invest in these funds only if you have an
zerodha.com/varsity
160
161
investment horizon of at least three years in perspective. Of course, with the
increased risk, the return expectation is also higher. I think it is prudent to
expect about 7 (ish) % return on these short-duration funds.
I think by now, you must have got the hang of how to understand the basics
of debt fund.
Here is the SEBI’s classification of a Medium duration fund –
As a task, why don’t you do look upon a fact sheet belonging to a medium
duration fund and answer these question –
How is the portfolio composition? What do they hold in the portfolio? How
are the papers rated?
What do you this is the credit risk here?
What is the Macaulay duration? Does it match SEBI’s mandate?
What is the modified duration? What do you think is the risk associated with
the interest rate change?
What is your investment horizon if you were to invest in these funds?
zerodha.com/varsity
161
162
I’m reasonably sure that you can carry out the above task with ease. If you
find any difficulty of any sort, then please do leave a query at the end of this
chapter and I’ll be more than happy to help you with it.
In the next chapter, we will take up the Credit risk, dynamic bonds and the
gilts. However, there is one last thing we need to discuss before we end this
chapter.
13.4 – The Franklin India debt fund saga
On 23rd April 2020, Franklin Templeton (India) AMC made an announcement
that shook the entire debt fund world.
zerodha.com/varsity
162
163
In an unprecedented move, Franklin has decided to close six of its debt funds,
which includes their low duration fund and ultra-short duration fund. The
AUM across these six funds is roughly Rs.27,000 Crores.
The reason they cite is – because of the current economic situation, there is a
surge in redemption, leading to a liquidity crunch within the AMC.
zerodha.com/varsity
163
164
To put this in perspective, Franklin witnessed a surge in redemption to the
extent of over Rs.9000 Crores in March 2020, which as you can imagine is
one-third of the AUM across these funds.
Unfortunately, the secondary bond market in India is not liquid enough. It is
not easy for the fund managers to quickly liquidate the bonds from their
portfolio. For this reason, most of the bonds held to maturity. Of course, the
AMC plans to have enough cash to meet daily redemptions, they do this in
several ways, including a technique called laddering, wherein they have a
blend of papers maturing in different timelines. The liquidity arrangements
work when business functions as usual. But as we clearly understand now,
things go helter-skelter when tables turn.
None of the AMCs would be (at least up until now) prepared for such a steep
surge in redemption.
Hence to ease the situation, Franklin has decided to close down the schemes
completely and lockdown the funds entirely, which implies that if you are an
investor in these funds, then you cannot place a redemption request.
Please note, the AMC is not winding down the scheme because of the credit
or interest rate risk. Folks at Franklin are outstanding in the debt fund game,
and they have vast experience in this segment, but unfortunately, they are
now threading on a different territory.
Therefore, dear readers, when investing in debt funds, along with the credit
and interest rate risk, factor in a new risk – liquidity risk.
zerodha.com/varsity
164
165
But of course, how do you quantify and apply liquidity risk in a real-life
scenario? Well, I don’t know that just yet. However, does this mean that you
should completely stay away from debt funds?
No, not at all.
Debt funds play an essential role in asset allocation, and it should play its
part in your portfolio. The COVID19 situation, if not for anything, has yet again
highlighted the importance of asset allocation.
More on this as we cruise through this module!
Stay home, stay safe!
Key takeaways from this chapter
● Bond yields and bond prices are inversely proportional
● Interest rate and bond prices are inversely proportional
● Modified duration helps us understand the change in NAV of
the fund (in the context of debt fund) for every 1% change in
interest rate
● Low duration fund has credit risk, but low-interest rate risk
● Money market fund has credit risk, but low interest rate risk
● Short and medium duration fund has both credit and interest
rate risk
● Debt investors have to factor in liquidity risk along with credit
and interest rate risk
zerodha.com/varsity
165
166
CHAPTER 14
The Debt Funds (Part 4)
14.1 – Liquidity Risk
In the previous chapter, we discussed the Franklin debt fund saga. Thanks to
this episode, as investors, we now very clearly know that investing in debt
fund should not be based on useless parameters such as the past returns or
the current fund ranking. The market has taught us one two many times that
this approach to fund selection is a pointless affair.
The evaluation must be based on risk metrics. Unless the investor develops a
sense of all the risk involved while investing in a debt fund, he or she should
not even venture into the debt fund arena. The same holds for equity funds
as well. However, thanks to the tagline ‘Mutual funds are subjected to market
risk’, investors somehow perceive market risk as a risk associated (only) with
equity funds. Still, at least they are aware of the fact that equity funds are
risky.
Unfortunately, the same set of people assume that the debt funds do not
carry any risk.
If you have read the previous chapters, you know that debt funds are risky
too, and you are even familiar with the risk types associated with debt funds,
i.e. default risk, credit risk, and the interest rate risk. The recent Franklin
episode formally introduced us to another dormant risk factor called the
‘Liquidity Risk’.
zerodha.com/varsity
166
167
We will start this chapter with a quick discussion on liquidity risk and then
proceed to learn the other categories (sub) of debt funds.
Liquidity risk, from the debt fund perspective, can mean two things –
● The lack of liquidity in the underlying market the debt funds invests in,
i.e. the Indian bond markets.
● The lack of availability of funds with the AMCs to service investor’s
redemption
Both these are tightly related though.
The lack of liquidity in the bond market implies that the AMCs cannot quickly
liquidate the papers they hold in the bond market, which means to say that
they are obligated to keep the paper to maturity, which further implies that
the money is kind of ‘locked-in’.
zerodha.com/varsity
167
168
Now the primary job of an AMC is to collect money from an investor, invest
that money on their behalf, generate returns for the investors, and return the
funds when the investor redeems the units.
To honour the investor’s redemption, the AMC must hold enough cash across
each of the schemes. If the AMC does not have enough funds, then they
cannot service the redemption requests that come in, especially in case the
redemption requests come in large numbers.
Think about it for a second – on the one hand; the AMC has invested in debt
papers which it cannot sell as and when they wish (lack of liquidity in bonds
market) and on the other hand, it has to maintain a cash pile to service
redemptions. In the event redemption comes in large numbers, the lack of
cash causes a liquidity crisis.
Franklin India faced this same situation. One a day to day basis, AMCs
maintain enough cash to service redemptions, aer all, redemptions are a
regular affair for an AMCs.
However, if there is a surge in redemption, then the AMC will need extra cash
to service the redemption. Question is where they will get this money?
You guessed it right, they borrow.
Under SEBI’s guidelines, an AMC can borrow up to 20% of its net asset under
management (AUM). You can read the detailed directions here –
Here is the extract on AMC’s borrowing limits –
zerodha.com/varsity
168
169
So, if an AMC is pulling this lever to borrow funds, then it probably indicates
that the AMC’s usual cash pile is depleting; hence they need to borrow more
to service redemption request.
How do we get to know if the AMC is borrowing? Well, one needs to look at
the monthly portfolio declaration that the AMC makes. If the cash component
is positive, that means to say that the AMC is not borrowing funds, if it is
negative, then that shows the presence of debt.
Take a look at Franklin’s Ultra-short Term fund’s portfolio from Jan 2020 –
Portfolio in Feb 2020 –
Portfolio in March 2020 –
zerodha.com/varsity
169
170
As you can see, the cash component turned negative in March 2020, which
means to say that the AMC had borrowed funds, showing some early signs of
liquidity stress. Franklin folded this particular fund along with five others on
23rd April 2020. So there was some warning on the wall.
There are a couple of things to note here –
● Just because you see a negative cash value, do not jump into the
conclusion that the fund is about to go bust. Develop a sense to
connect the dots to understand what is happening.
● The negative cash component can be a lagging indicator – remember
the AMC’s portfolio details comes out with a delay; nevertheless, this is
still a good indicator of trouble.
So if you are a ‘do it yourself’ investor, then do keep an eye on this every
month. The onus is on you to figure the development in the market and
connect these dots. What do I mean by ‘connect the dots’? Could I connect
the dots and developed a foresight into what would happen to Franklin in
March itself?
These are tough questions to answer. Today, I have the benefit of hindsight,
and therefore I can lay down a list of things –
● Franklin’s Vodafone episode was the first warning sign.
zerodha.com/varsity
170
171
● The individual portfolios consisted of papers below AA+; this was
always questionable.
● Cash decreased, borrowings increased.
● The market itself was weak, thanks to COVID 19
● The street sentiment was negative.
When you connect these things, you’d somehow see trouble brewing. I
understand it may not be straightforward for a regular investor (or for that
matter even seasoned analysts), with more market experience the ‘connect
the dots’ bit becomes more intuitive and the call will eventually come from
your gut
🙂
We will discuss more on this and other aspects of risk in the ‘how to select
mutual funds’, chapter. We will now proceed to understand three different
types of debt funds – Banking & PSU Debt Funds, Credit risk funds, and the
Gilts.
14.2 – Banking and PSU Debt Fund
Ideally, I’d have stopped discussing debt funds right aer the medium
duration funds, because in my opinion, all the other types of debt funds are
entirely pointless for a typical retail portfolio.
However, I think it is important to discuss other debt fund types to let you
know what they are and what to expect.
Let us kick start this discussion with the Banking & PSU Debt Funds.
zerodha.com/varsity
171
172
Before we proceed, think about this a bit and try to imagine what the
‘Banking and PSU debt Fund’, really means.
If you are someone like me, I’m sure you’d have thought that the Banking and
PSU debt Fund, as the name suggests is a fund that invests in papers from the
banking and PSU sector. The banking and PSU sector is as one of the safest in
India.
Fair enough now let’s see what SEBI has to say –
Well, it looks like we were almost right
🙂
The fund invests in banking and PSU debt to the extent of 80%. Pay attention
to the 80% part here!
The remaining 20% gets invested in any paper.
Suddenly what seemed like a harmless debt fund turns out tricky.
This is an 80-20 cocktail, and there is a problem with it. Think about this from
a regular retail investor, when he reads the fund’s title; it is only natural for
him to expect the fund to be 100% Banking and PSU debt, he would not
expect the fund to have papers from the private sector.
If a default occurs in any of the paper from the 20% bucket, then the fund’s
NAV takes a hit. Who is to blame here? The investor for expecting a pure-play
Banking & PSU fund, the fund manager for lousy investment, or SEBI for
permitting this cocktail?
zerodha.com/varsity
172
173
Have a look at IDFC AMCs Banking & PSU Debt Fund –
The portfolio consists of paper from Reliance Industries to the extent of
1.27%, not that Reliance is terrible, could be a fantastic paper to hold. Still,
the question is, does it belong here?

Anyway, the good part of the Banking and PUS Debt fund is that the credit
risk is kind of on the lower side, mainly for two reasons –
● RBI provides liquidity support to banks and NBFCs
● Implicit Sovereign guarantee by the Govt of India for PSUs
But remember, the ‘credit risk comfort’ is for 80% of the portfolio; the same is
not valid for the balance of 20% of the portfolio.
zerodha.com/varsity
173
174
Also, if you notice, SEBI has no specs on the Macaulay’s duration of the
portfolio, which means the fund manager is flexible with the duration of the
papers held in the portfolio. Given this, the modified duration will be on the
higher side for these funds.
Here are the parameters for the IDFC’s Banking & PSU Debt fund –
The average duration is about 3.1 years, which is in line with any mid duration
fund. The modified duration is about 2.6, which for a debt fund is on the
slightly higher end of the spectrum. If the interest rate goes up, the fund will
take quite a bit of time to recover from the fallen NAV.
Given this, an investor looking at investing in these debt funds should have at
least 3-5 years perspective while investing in the Banking & PSU Debt fund.
At this point, I think it is important to remind the readers that so far in this
module, we are only introducing different types of fund. We have made few
passing comments on some of these categories, but we still haven’t figured
how and why one should invest if at all one has to.
At a later point in this module, we will try and figure two significant bits –
● How to analyse a Mutual Fund?
● How to build an MF portfolio?
When we do this discussion, we will tie all loose ends and develop a holistic
approach to personal finance.
zerodha.com/varsity
174
175
14.3 – Credit Risk Funds
Before October 2017 (before SEBI’s huge MF reclassification circular), Credit
Risk Funds were called ‘Credit Opportunities Fund’.
Do you notice the change in perception here?
Credit Opportunity Fund – the emphasis is on the opportunity, returns, and
generally has a positive feel to it, hence easier to sell
🙂
Credit Risk Fund – It’s the same fund, but by highlighting the term risk, the
emphasis is on the risk, and rightly so.
Anyway, the name ‘Credit risk fund’, should give you a heads up on what to
expect in this fund
🙂
Yes, you guessed it right, the fund is loaded with Credit Risk!
As usual, let us start with SEBI’s definition –
And if you are wondering what the little circumflex next to the name points to
–
SEBI here simply specifies that an AMC running a credit risk fund should
invest 65% of the assets in corporate bonds, which are ‘below are below the
investment grade, which means –
zerodha.com/varsity
175
176
● These bonds carry maximum credit risk, hence the probability of both,
default by the bond issuer and credit downgrade is very high
● No spec on where the balance 35% gets invested
The Credit risk fund is where the fund managers cut themselves to chase
yields. Think of it like a hungry kid at a buffet dinner party. The plate will be
loaded, with zero control on what gets packed in the plate.
Similarly, a fund manager running a credit risk fund loads up the portfolio
with risky papers to chase yields. Let me explain this.
The objective of a credit risk fund is to take on as much credit risk as possible
to ensure a higher yield to the investors. What does this mean?
This means the fund will lend the investor’s funds to corporates whose
repayment track record or repayment capability is questionable. Why would
the fund manager deliberately lend to a corporate who is unlikely to repay?
He does so because the corporates in need of the fund say, ‘give me the
money, and I’ll compensate you with higher interest rates’.
You see the point, right? Corporate with bad credit history has to entice new
lender by paying a higher coupon rate.
The debt papers of such corporates usually have a lower rating. When the
fund manager lends to such entities, he hopes for the following –
● The borrowing entity will repay and honour the interest paid regularly.
● He also hopes the corporate entity improves its creditworthiness.
zerodha.com/varsity
176
177
● If the creditworthiness improves, then the rating of the bond/paper will
improve.
● If the ratings improve, the bond price goes up, hence the NAV increases
If these things were to happen, not only will the fund manager get higher
interest rates for the money he has lent, but will benefit from the credit rating
upgrade and the eventual increase in bond prices.
Let us look at a portfolio of a Credit Risk Fund; this belongs to DSP’s Credit
Risk fund –
The fund manager here has decided to allocate nearly 30% of its assets to just
one company. You can imagine the hit on the NAV of this fund if this company
were to default on its obligation.
The credit ratings of the other companies are not excellent either; well, this is
expected from a credit risk fund. Still, the combination of concentrated
positions coupled with lousy credit ratings makes this a hazardous category
to invest.
zerodha.com/varsity
177
178
The credit risk fund is a complicated category to understand, but the good
part is that a retail investor does not need to endure this pain.
Almost all portfolio goals of a retail investor can be achieved without GILTS in
the portfolio. So do avoid investing your money in a credit risk fund.
14.4 – GILT Funds
Back in the early 19th Century, when the Government would borrow money,
they would do so by issuing a bond (a physical paper), on which the terms of
the borrowing were written and signed. The edges of such a bond were laced
in Gold, to showcase the sanctity of Government borrowing. Such bonds
issued by the Government were called the ‘Gilt-edged bonds’, because of
golden edges.
The presence of Gold does not eliminate the credit or interest rate risk, at the
end of the day, this technically is still a bond
🙂
However, the fact that the borrower is the Government implies that there is
virtually zero Credit risk, because, well, the Government cannot default on
debt obligations.
The legacy continues, and even today, the bonds issued by the Government is
called a GILT, there is no gold lacing today, but the Sovereign Guarantee still
exists.
Now, as you can imagine, a mutual fund that invests predominantly in
Government bonds or Gilts is called a ‘Gilt Fund’.
Here is SEBI’s definition of a GILT fund –
zerodha.com/varsity
178
179
There are two types of GILT funds –
● Gilt funds – Invests a minimum of 80% of its assets in Government
securities. This implies 20% can go anywhere (again the cocktail
problem)
● Gilt with ten-year constant duration – This fund is the same as above
with the added clause that the Macaulay’s duration is at least ten years.
By defining the duration, the entire risk profile of this fund changes.
Agreed, there is no Credit risk for the investor here. We expect the
Government never to default. But think about the interest rate risk in these
funds, especially the constant duration one. As you can imagine the interest
rate risk is quite significant in these funds, probably large enough to
compensates for the absence of credit risk.
I would urge you to look into the fact sheet of any GILT fund and observe the
duration and modified duration to get a sense of how risky these funds are.
If you ever decide to invest in these funds, then do so only with a long, really
long term perspective. I’m talking about 8-10 year time frame here.
I really don’t see a need for a GILT fund in any retail portfolio; you are better
without this.
zerodha.com/varsity
179
180
Anyway, with this, we will wrap up our discussion on debt funds. Up next is
ETFs and Index funds.
Key takeaways from this chapter
● A debt fund investor should watch out for liquidity risk
● The cash borrowings of a fund is an indicator of liquidity risk
● The Banking and PSU debt funds invest predominantly in
banking/financial services, and PSU debt
● The banking and PSU debt carries less credit risk (relatively)
compared to its peers
● Credit risk fund carries a high degree of credit risk. A retail
investor is better off avoiding this fund
● GILTS don’t have credit risk but have a significant amount of
interest rate risk
zerodha.com/varsity
180
181
CHAPTER 15
Investing in Bonds
15.1 – Context
I understand we concluded the previous chapter by hinting that we would
discuss Index funds next. However, I’m taking a bit of a detour to introduce
how one can invest in Bonds directly.
Why am ‘I doing this now? Well, that is because we have just discussed debts
funds and the associated terms, given the similarity between debt funds and
bonds, I thought we could extend that discussion and talk about bonds as
well.
Besides, Zerodha’s bond investing platform is up and ready for you to use, so
this chapter will help you understand how to use the platform as well.
zerodha.com/varsity
181
182
Remember, when you invest in any sort of debt mutual fund, you primarily
invest in a mutual fund whose fund manager invests your funds in various
bonds and bills. Using Zerodha’s platform, you can now directly invest in the
bonds, just like the fund manager would.
15.2 – The bonds platform
The bonds platform on Zerodha is a part of Coin, our mutual fund platform.
On the landing page, you can see that we are talking about high-quality PSU
and Corporate Bonds. High quality here means the highest credit ratings.
At any given point, the platform lists all the available bonds for you to invest.
As of today, these are the bonds available to you –
zerodha.com/varsity
182
183
For example, the very first is a bond from Rural Electrification Corporation
Limited (REC).
There are two tags below the company’s name; these tags give you vital
information on the bonds.
● PSU Tax-free – Remember, PSUs carry an implicit Sovereign guarantee;
hence the credit risk in these PSU bonds is very low. The tax-free bit
indicates that the interest income received from these bonds is 100%
tax-exempt. The tax-free bit makes these bonds extremely attractive for
the investors. However, the tax-free is applicable only for the interest
income. If you hold the bond till maturity, there will be no taxation on
zerodha.com/varsity
183
184
your interest earnings from this bond. However, if you manage to sell
this bond before maturity at a price more than what you had
purchased, then you get capital gains which are taxable.
● Credit Rating – REC Limited’s bond is rated triple-A (AAA) by CRISIL; the
rating is an indication of the creditworthiness of the borrower. AAA is
the highest-ranking, so one need not worry about the creditworthiness
of the borrower, i.e. REC in this case.
Apart from these tags, there are other specs available to you. Some of these
are easy and intuitive, while the others are not.
On the platform, you can see a summarized view of the most important
parameters for you to consider before investing. A typical investor does not
need any more information apart from what’s listed above.
However, for the sake of this chapter and its completeness, let’s dig into
more details of this particular REC bond. The ISIN of this bond is
INE020B07HO1, key in the ISIN here and you’ll get all the other information
related to this bond.
I’ve highlighted the most significant bits here –
zerodha.com/varsity
184
185
Let’s start with the first item from the le. As we can see, this is a secured
debt . A secured debt is a loan backed by security. The classic example is a
Gold loan.
In a gold loan, you pledge the gold and raise a loan against it. When you repay
the loan, the pledge on gold goes away, and you get back the gold. In case
you don’t repay the loan, the lender is free to take your gold and make good
for his loss.
Given this, if you look at it from the lender’s perspective, a secured debt gives
the lender a higher comfort compared to unsecured debt.
In the next section, you can see that this is senior debt.
Every company has something called ‘Capital Structure’. The capital structure
is like a leader board of sorts, which mandates the list of stakeholders who
have the highest claim on the company’s repayment and earning structure.
The senior secured debt sits right at the top of a capital structure, while a
common stock (equities) sits right at last. Between the senior debt and
zerodha.com/varsity
185
186
equity, lie other stakeholders like the unsecured debt, convertible bonds,
non-convertible debt etc. In case of liquidation of the company (worst case
scenario), the senior debt holders are the first ones to be paid off from the
liquidation amount of the company. This significantly enhances the safety of
capital for senior debt holders.
So the moment you see secured senior debt, be assured that the credit risk
associated is relatively very low.
The section aer this is quite self-explanatory, talks about the date of issue.
Think about this as the company’s IPO date or an NFO debuting in the MF
market.
REC paper was issued in 2013, maturing in 2023, making this a 10-year bond.
Now move your attention to the details mentioned on the right — the
topmost section details out a few essential parameters.
Firstly, the face value, which is Rs.1000/-. The face value of a bond is essential
for three reasons –
1. Gives you a sense of the premium or discount the bond is trading to its
face value. In the case of REC (refer to the snapshot from COIN), the
current price for this bond is Rs.1115.03/-, which is at a premium to face
value.
2. The coupon is paid as a percentage of the face value. The coupon for
this bond is 8.01%, which means that every bond you hold gives you
Rs.80.01/- as interest income until it matures.
3. Upon maturity, the redemption value depends on the bond’s face
value. More on this later.
zerodha.com/varsity
186
187
The next section highlights the interest payment details. As highlighted, the
REC bond pays the interest on 1st Dec every year, till the bond matures. The
company pays out interest annually. Some bonds pay interest semiannually,
quarterly, and some even pay monthly.
You can also see the maturity date, which is 24th September 2023.
Now that you know these details, I’d suggest you re-look at the COIN
snapshot. Everything mentioned in the snapshot should be clear, except for
the YTM.
15.3 – Yield to Maturity
The concept of ‘Yield to Maturity’ or YTM is one of the most important
concepts to understand when dealing with bonds. While the bond’s coupon is
essential, as an investor in bonds, you need to be more concerned about the
YTM than the coupon itself.
I think the concept of YTM is best understood if we look at it from transactions
we are familiar with. Given this, let us build a hypothetical situation around
this.
Scenario 1
Your friend informs you about a fantastic commercial property, capable of
giving you a 20% rental yield on the investment.
Rental yield = Total rent collected in the year / Amount invested in the
property.
zerodha.com/varsity
187
188
You get all excited, because, from your research, the average commercial
rental yield is about 15%, so the deal your friend proposed stands out. You
ask your friend for more information.
He tells that the fair price for the commercial property is 3 Crores. You do not
bat an eyelid; you pay 3 Crore cash down and buy the property.
From the next month, you start receiving a rent of Rs.500,000/- into your
account.
Twelve months pass by, and rental income is flowing smoothly.
However, at the end of 12 months, you have a premonition that a virus will hit
the world, people will start working from home, and therefore the
commercial real estate will lose its sheen.
You decide to sell the property and cash out. Assume the property market
stayed flat; hence, you get to sell the property at cost, i.e. 3 Crore.
The question is, how much did you make on this entire transaction? In other
words, what was your Net Yield? For the sake of simplicity, forget about taxes
and charges.
This is a straightforward calculation –
Buy Price = 3 Crore
Sell Price = 3 Crore
P&L on Property = 0 ———- (1)
Rental per month = Rs.500,000/-
zerodha.com/varsity
188
189
Number of months rent collected = 12
Total Rental income = 12 * 500,000 = Rs.60,00,000/- ————– (2)
Net P&L = (1) + (2)
= Rs.60,00,000/-
Net Yield = Net P&L / Buy price
= 60 Lakh / 3 Crore
= 20%
The net yield equals the rental yield.
Scenario 2
Everything remains the same, except that at the time of buying, instead of 3
Crore, you bought the property at 3.3 Crore. What is the net yield?
Buy Price = 3.3 Crore
Sell Price = 3 Crore
P&L on Property = A loss of 30 Lakh ———- (1)
Rental per month = Rs.500,000/-
Number of months rent collected = 12
Total Rental income = 12 * 500,000 = Rs.60,00,000/- ————– (2)
Net P&L = (1) + (2)
= Rs.30,00,000/-
zerodha.com/varsity
189
190
Net Yield = Net P&L / Buy price
= 30 Lakh / 3.3 Crore
= 9.09%
Notice, everything remained the same, except for the buy price. However, this
had a big impact on the net yield.
Scenario 3
Everything remains the same, except that at the time of buying, instead of 3
Crore, you bought the property at 2.9 Crore. What is the net yield?
Buy Price = 2.9 Crore
Sell Price = 3 Crore
P&L on Property = +10 Lakh ———- (1)
Rental per month = Rs.500,000/-
Number of months rent collected = 12
Total Rental income = 12 * 500,000 = Rs.60,00,000/- ————– (2)
Net P&L = (1) + (2)
= Rs.70,00,000/-
Net Yield = Net P&L / Buy price
= 70 Lakh / 3 Crore
= 24.14%
zerodha.com/varsity
190
191
Notice, in all the three scenarios, the rental yield was fixed at 20% that dint
change at all. But the net yield changed, based on the transaction prices.
In summary –
● The rental yield and the net yield matches only when the buy and sell
remains the same
● The net yield is lesser than the rental yield when the buy price is higher
than the selling price
● The net yield is higher than the rental yield when the buy price is lower
than the selling price.
The point that I’m trying to make here is that net yield is very different from
the rental yield.
Now, let us snap back to the bonds world and make few comparisons –
Buy price of the property = Buy price of the bond
Sell price of the property = Sell price of the bond
Rental yield = Coupon
Net yield = Yield to maturity or YTM.
Look at this again –
The coupon is 8.01%, but the YTM is 5.4%. Why do you think the YTM is lesser
than the coupon itself?
zerodha.com/varsity
191
192
Well, that is because you buy this bond at Rs.1115.03/- and upon maturity,
this bond is redeemed at Rs.1000/- (scenario 2).
So the effective return you experience here is 5.4%.
15.4 – Accrued Interest
Clicking on the yellow invest button takes you to the next screen on the
platform, which gives you a bit more information on the bond.
I suppose you are familiar with most of the information present on this
screen, except for the accrued interest bit. The concept of accrued interest is
straightforward to understand.
We know the REC bond pays a coupon of 8.01% on Rs.1000/- face value. The
Rupee value of the coupon is Rs.80.01/-.
The coupon of Rs.80.01/- gets paid once a year or once in 365 days. We know
the date of payment is the 1st December every year.
The last coupon was paid on 1st December 2019, and the next coupon will be
paid on 1st December 2020. Between the previous coupon paid and the next
coupon date, interest accrues daily.
zerodha.com/varsity
192
193
If you do the math –
Daily accrued interest = Yearly coupon amount / 365
= 80.01/365
= 0.219452 Paisa.
Therefore, by holding this bond, the bondholder earns 0.219452 daily.
Today is 21st May 2020; it is 172 days since the last coupon paid. Therefore, by
holding this bond for 172 days, the owner of this bond is entitled to receive –
0.219452 * 172
= Rs.37.745/-
From the screenshot above, you can see that the accrued interest is
Rs.37.86/-, which is approximate to what we have calculated.
The settlement price seen is Rs.1115.47/-, which also includes the accrued
interest. Therefore, you can break the settlement price into two components
–
Settlement Price = Price of the Bond + Accrued Interest
= 1077.609 + 37.8615
= 1115.47/-
So why does the settlement price include the accrued interest?
Well, this is because when you buy the bond, you need to compensate the
bond seller the interest he has earned for the duration he has held the bond.
zerodha.com/varsity
193
194
Hence, the settlement price includes accrued interest. Also note that when
the next coupon is paid by REC, you as the current bondholder will receive
the full coupon amount of Rs.80.01/- (thus compensating for the accrued
interest that you paid to the seller).
While we are at it, a bit of bond terminology for you.
The settlement price is also called the ‘ Dirty Price ’ of the bond and the
settlement price minus the accrued interest is called the ‘ Clean price ’ of the
bond
15.5 – Should you invest in Bonds?
If you’ve read Varsity by now, you’d probably know me as a one hundred
percentage equities guy. I’ve mentioned this in several places with due
caution that 100% equity is not perhaps the right approach to build a long
term portfolio. I always knew that I have to fix this and start to diversify my
little savings. It’s just that I pushed my asset allocation plans further and
further.
Well, thanks to COVID, this happened –
zerodha.com/varsity
194
195
A 40% decline in the Index in less than a month. All gains wiped clean. For the
first time since I started investing in the markets, I saw that the ten year SIPs
go negative as well. I do not think this had happened in the 2008 market crash
either. Look at this chart; I’ve got this from Value Research website –
Perhaps this is a strong enough reason for me to get started with asset
diversification. Maybe it is a good idea for you as well if you have not thought
of asset allocation yet.
On the asset side, you now have access to –
zerodha.com/varsity
195
196
● Direct Equities
● Equity Mutual funds
● Direct Bonds
● Debt Mutual funds
● Sovereign Gold bonds
● Fixed Deposits from your bank
I think with these assets; you can build any combination of the portfolio with
different asset allocation patterns to achieve any portfolio goal.
In the coming chapters, I will discuss portfolio compositions and how you can
set up portfolios to match your goals, but before we do that, we will next
discuss the Index fund.
Stay tuned.
Key takeaways from this chapter
● In a tax-free bond, the coupons are tax-free
● PSU debt carries an implicit sovereign guarantee, and hence
very low credit risk
● The coupon is paid as a percentage of the face value
● YTM of a bond is the effective yield the bondholder
experiences
● The bond buyer pays accrued interest to the bond seller
zerodha.com/varsity
196
197
CHAPTER 16
Index Funds
16.1 Overview
In chapter 6 & 7 , we discussed the basics of a mutual fund and how a fund
works. Just to recap, a mutual fund is a pooled investment vehicle that takes
your money, invests and manages it on your behalf. What distinguishes one
fund from another is the management part. There are 100s of strategies that
AMCs employ but broadly speaking, you can categorize them as:
● Active
● Passive
In an active mutual fund, the fund manager tries to beat a benchmark or
deliver alpha . In simple terms, alpha is the excess return above a benchmark.
Before we go further, it’s important to understand what a benchmark is and
why do you need a benchmark. A benchmark serves as a point of reference
for measuring performance because you cannot look at the performance of a
mutual fund in isolation. Every mutual fund benchmarks itself to an index like
the Niy 100, Niy Midcap 150, Niy Smallcap 100, etc depending on the
category it operates in. Benchmarks also give you an idea of the returns you
would’ve made if you had done nothing and just bought the index.
Now, the job of the active manager is to deliver returns over and above the
benchmark. He does this by actively picking stocks or based on various
strategies and by deviating from the benchmark to various degrees. For
zerodha.com/varsity
197
198
example, one of the most widely used strategies among mutual funds is Value
investing. Here a manager tries to pick stocks that are cheaper than their
intrinsic value. On the other end of the spectrum, there’s growth investing
where a manager invests in companies, as the name implies that is growing at
a faster rate than their peers/industry and also invest most of the earnings
back in the business to fuel the growth. Similarly, there are hundreds and
thousands of approaches and strategies used by managers, which is outside
the scope of this chapter, but I hope you got the idea. The job of an active
manager is to beat the benchmark.
A passive fund or an index fund, on the other hand, simply tracks the
performance of a benchmark as closely as possible. It does not try to
outperform or underperform the benchmark, but just match the returns
before costs (expense ratio). Mutual funds have costs, so the return of an
index fund, broadly speaking, will be the benchmark returns minus costs.
So, when you invest in a Niy 50 index fund, all you are getting is Niy 50
returns. If Niy 50 returns 10% this year, your return will be 10% minus the
expense ratio. It’s as simple as that.
zerodha.com/varsity
198
199
16.2 History
Before we look at the performance of active funds, why index funds make
sense etc, I think it’s important to know a little history about how index funds
came to be.
The story of how the first index fund came to be is quite fascinating. John C.
Bogle, also known as Jack Bogle, the founder Vanguard, launched the first
index fund in 1976. The fund was called the First Index Investment and
tracked the S&P 500 Index. The fund was later renamed as the Vanguard 500
Index Fund. For context, the S&P 500 consists of the 500 biggest US
companies, and the index is a market capitalization-weighted. Meaning, the
total free float outstanding shares of a company are multiplied by its price
zerodha.com/varsity
199
200
and higher the value, higher the weight of that stock in the index, and it’s that
simple. Niy and Sensex follow the same methodology as well minus a few
technicalities.
The crazy thing about the first index fund is that the launch was an abject
failure. Vanguard led by Jack Bogle was hoping to raise $150 million during
the underwriting process but managed to raise just $11.3 million. They didn’t
even have enough money to buy all the shares in the index. What they ended
up doing is they sampled the index, they just bought enough stocks across
sectors to broadly resemble an index, and it worked out well in the end. If
Jack Bogle had given up, we probably would have had to wait longer for an
index fund and history would have been much different.
Even though it was launched in 1976, the Vanguard 500 Index Fund didn’t
reach the $1 billion mark until 1990. As of writing this chapter, however, the
fund has $500 billion in assets and is the largest mutual fund on the planet.
This fund alone is bigger than the entire Indian mutual fund industry, which
has about $350 billion in assets. As for Vanguard, it is the second-largest AMC
in the world with over $6 trillion in assets, next only to Blackrock, which has
close to $7 trillion in assets.
India
IDBI Principal was the first AMC to launch an index mutual fund tracking Niy
in India. The scheme later became the Principal Niy 100 Equal-Weight fund.
Benchmark AMC was the first to launch Niybees – an index exchange-traded
fund (ETF) tracking the Niy 50. Benchmark was later acquired by Goldman
Sachs India which was acquired by Reliance mutual fund which was acquired
by Nippon.
zerodha.com/varsity
200
201
Today, the biggest mutual fund in India is an Index fund – the SBI Niy 50 ETF
with over Rs 60,000 crores in AUM. Before you start thinking when did index
funds become so popular in India, they aren’t
🙂
Pretty much all of the
money in this ETF is from The Employees’ Provident Fund Organisation
(EPFO). It started investing in equities since 2015 and Niy, and Sensex ETFs
were the chosen routes. The AUM if Index mutual funds is a better proxy of
the popularity of these funds and as of April 2020, they just had Rs 8,800
crores in AUM.
This is nothing compared to the Rs 119,861 crores in active large-cap mutual
funds, for example.
16.3 Definition of an index fund
The active vs passive debate is one of the longest-running, loudest, and one
the most controversial debates in finance, I’ll get to that later. But even when
it comes to the definition of an index fund, there are widely different
thoughts. Today, any fund that tracks an index is called an index fund. You
can technically create an index of companies whose name starts with the
letter G and then launch a fund tracking that index. But the very first index
fund was tracked the S&P 500 which is a market capitalization-weighted
index. But according to the hardcore finance guys and academics, a true
index fund is one that tracks a broad cap-weighted index like the Niy 50,
S&P 500 etc.
zerodha.com/varsity
201
202
16.4 Do index funds work?
You may be wondering given that index funds just track a benchmark and not
seek to outperform, how do they even make sense, it’s a fair question.
Outperformance is always better than just benchmark returns, right? Let’s
unwrap this. There are a bunch of complicated ways this can be answered,
but here’s the gist. If you think about it, markets are a zero-sum game,
meaning for every person making money, somebody has to lose money.
Here’s an illustration to explain that: 
This means that all active managers collectively cannot beat the market. The
reason is cost, and they are the biggest drag on the performance.
Now forget that you read the previous paragraph for a minute and let’s look
at costs. An active mutual fund seeks to outperform any index, which means
it needs the resources to do so. This involves hiring a bunch of analysts,
getting the best Chief Investment Officer(s), the best research, the best tools –
zerodha.com/varsity
202
203
your Bloomberg Terminals what have you and other things. All this doesn’t
come cheap, and there are costs involved.
How much? Let’s compare the expense ratios of active large-cap mutual
funds and index mutual funds. Moneycontrol shows the category average
expense ratios, which allows you to quickly get a sense. The category average
expense ratio of active mutual large-cap mutual funds (direct plans) is 1.28%
The category average for index funds, on the other hand, is 0.31%.
Note: the average expense ratios will be far higher for regular plans of mutual
funds.
That’s almost a 1% difference. Though this might seem small, costs
compound over a long period and significantly eat into your returns. If you
are investing on Coin, you’d have already realized this and made the smart
choice. But just to reiterate, you can use the savings calculator on Coin to
calculate the impact of costs. Here’s the difference between paying .6% and
1.6% on a Rs 10,000 SIP over 20 years. That tiny 1% difference will cost you Rs
12.8 lakhs.
zerodha.com/varsity
203
204
Assuming that an active mutual fund is charging 1.5% is benchmarked to
Niy 50 for example and let’s assume that the Niy Index fund charges 0.10%.
Right out of the gate, the active fund is at a disadvantage and has to generate
1.4% just to keep up with the benchmark, and I am not even talking about
outperforming the benchmark.
Index funds, on the other hand, are extremely cheap. The SBI Niy ETF
charges 0.07% for comparison. The reason why index funds and ETFs are
cheap is that they don’t need highly paid star fund managers, research teams
etc. All they have to do is copy an index, and that’s it.
16.5 Historical Performance
Let’s look at the historical performance of active funds and index funds. I
know at this point, you are thinking about those huge past returns displayed
prominently on AMC sites, Value research and elsewhere. S&P – the world’s
zerodha.com/varsity
204
205
largest index provider publishes a semi-annual report called the S&P Indices
Versus Active ( SPIVA® ) scorecard. This report looks at the performance of
active funds versus a standardized benchmark period for 1,3,5,10 periods.
Here’s how the Indian active mutual funds have fared as of the end of 2019 . 
On 5 years, 82% of active large-cap funds have underperformed the S&P BSE
100 index, which consists of the 100 largest Indian companies by market cap.
Although the performance of mid and small-caps looks promising, things
seem to be changing. With the recategorization exercise, SEBI has clearly
defined the universe of stocks fund managers can invest in which will make
outperformance harder. Up until last year, we didn’t have mid-cap index
mutual funds, we had ETFs, but they were illiquid. Several AMCs have started
launching them over the past year or so.
As for small-caps, active or passive, I don’t think investors should invest in
these funds at all. They seem to fall as fast as they go up, which makes it
frustrating for investors to hold on to. That gut-wrenching volatility also
increasing the chances of investors buying high and selling low.
16.6 Bottomline
Based on the numbers at any given point, your chances of picking a
consistently performing active fund is worse than 50:50. In the case of
large-caps, it’s consistently worse. And it’s going to get worse as the Indian
capital markets deepen. Let’s take the case of large-caps, and there are 40
AMCs and 40 large-cap funds. Broadly speaking everybody pretty much has
access to the same information and everybody can only invest in the top 100
zerodha.com/varsity
205
206
stocks, outperforming the benchmark isn’t easy, not to mention the cost
disadvantage they have vs index funds.
And there’s also the issue of funds just hugging benchmarks which is quite
common – this is also referred to as closet indexing. Most funds don’t deviate
significantly from the benchmarks, and aer expenses, they are guaranteed
to underperform the index.
There’s another way of looking at this. Famed researcher Michael
Mauboussin, in this paper , termed this the paradox of skill:
“In cases where two or more players have the same level of skill—whether that
skill is high or low doesn’t matter—the skills of the players offset one another
and luck becomes the primary determinant of the outcome. “Players” can be
athletes, investors, or business executives. In many competitive realms,
including investing, the skills of the participants have improved on an absolute
basis but have shrunk on a relative basis. Today’s investor has vastly more
resources and training than his or her predecessor from years past. The
problem is that investors, broadly speaking, have gotten much better which
means that the difference between the skill of the best and the average
participant isn’t as great as it used to be”
16.7 Fixed income (Debt)
So far, when I say an index fund, I’ve meant equity index funds. Globally in the
last 5-10 years index funds including debt index funds, have experienced
phenomenal growth. Bond ETFs recently crossed the $1 trillion mark in the
US. In case you are wondering if there are any debt index funds in India, these
are very early days for equity index funds, let alone debt index funds. Except
zerodha.com/varsity
206
207
for the recently launched Bharat Bond ETF and fund of fund, we don’t have
any debt index funds.
The Indian debt markets are very tiny and notoriously illiquid. Except for
G-Secs and the best AAA-rated bonds, most other bonds trade sparingly. And
unlike equities which trade on the exchanges and there’s transparent price
discovery, most of the trading activity in bonds happens over the counter
(OTC) or off-market. It’s the same even in the US, where the debt market is
bigger than the equity market.
This, among many other things, makes indexing debt very hard, but maybe as
the markets evolve, things should change. There are companies like
Tradeweb trying to bring electronic trading to the bond markets.
16.8 Active or passive (Conclusion)
Aer reading all this, you might be wondering if you should choose active or
index funds. It’s not active or passive but active and passive. You can mix both
in your portfolio and have allocation based on your risk tolerance. But always
pick a fund that has a long track record and sticks it’s stated mandate. Before
the SEBI scheme recategorization exercise, funds didn’t have any restrictions
on how they could invest. Some funds used to be labelled large-cap and used
to invest in mid-cap and small-caps to juice returns. So, picking a fund where
the manager does what he says is important. Funds with cowboy managers
pretty much always end up as disasters.
zerodha.com/varsity
207
208
I have also mentioned exchange-traded funds (ETFs) in the chapter, although
they are similar to index funds, there are some important differences. In the
next chapter, we’ll discuss ETFs. Similar to index funds, there’s a category of
funds called smart-beta funds, which have grown increasingly popular over
the past decade. The term “smart beta” is meaningless, at the core these are
rules-based funds, and we’ll also briefly understand the basics.
zerodha.com/varsity
208
209
CHAPTER 17
Arbitrage Funds
17.1 – Arbitrage
We were to move ahead and discuss MF attributes and gradually steer our
way to identify techniques of building a mutual fund portfolio. While I was all
set to do that, I just remembered we hadn’t discussed the ‘Arbitrage Funds’,
which for some reason has all the market attention these days. So I’ll keep
this chapter short, consider the Arbitrage fund and move ahead.
Before we understand the ‘Arbitrage Fund’, we need to understand what
‘Arbitrage’ means. Of course, if you are a regular Varsity reader, then this is
something you guys are familiar. We have discussed arbitrage on a couple of
occasions, in particular, we have looked at arbitrage in the form of calendar
spreads, pair trading, and put-call parity.
For others who are not familiar with ‘Arbitrage’, here is a quick note.
All of us, at some point in life, would have carried out an arbitrage
transaction. For example, when I was in my 1st-year college, I’d pay my cousin
in Singapore to buy me Rock n Roll audio cassettes from Rs.100/- per tape
and sell the same here in Bangalore for Rs.150/-. People here would happily
buy the tape at Rs.150/- because there was no other source for them to buy
these tapes.
zerodha.com/varsity
209
210
The above is an arbitrage transaction.
In an arbitrage transaction, you buy an asset (like the audiotape) from one
market (Singapore) where the asset is selling cheap (Rs.100/-) and sell the
same asset (the audiotape) in another market (Bangalore) for a higher price
(150). The arbitrageur (i.e. me in this example), makes a risk free profit
(Rs.50/- in this case).
If you think about this, arbitrage is beautiful, right? If the above were to hold,
all I had to do in life was buy tapes from Singapore and sell the same in
Bangalore. I do this in large quantities, and I’d be sitting on a massive pile of
cash.
But if only life was that easy
🙂
The assumption here is that there are continuous supply and demand in both
markets. I mean imagine a situation where I buy tapes worth Rs.100,000/-
with a hope to sell it for Rs.150,000/- and suddenly I realise that people in
zerodha.com/varsity
210
211
Bangalore are no longer interested in Rock n Roll, but instead prefer listening
to Boyzone! Then my money is gone, right?
So the point is, unlike the popular notion, arbitrage is not risk-free. What we
discussed is an example of the supply-demand risk associated with the
arbitrage opportunity.
But it is not just that.
Imagine another scenario, where a friend of mine figures my little trick, and
he does the same, i.e. buy tapes from Singapore at Rs.100/- but sells the same
at a slightly lower rate at say Rs.140/- to ensure he beats me at my own game.
What do you think would happen next? A price war would break, I’d offer the
same at say 135, he would then reduce to 125 so on as so forth till all the
margins evaporate.
Point being, arbitrage opportunity or arbitrage profits shrink when more
people try to exploit the same opportunity.
Now, think about the stock markets. Take a look at the snapshot below –
What you see here is the quote for Kirloskar Industries, on NSE it is trading at
562.4 per share, and on BSE the same company is trading at 546.40 per share.
There is a difference of 16 Rupees.
zerodha.com/varsity
211
212
The above is an arbitrage opportunity. All you have to do is buy Kirloskar
Industries at 546.4 in BSE and sell the same stock in NSE at 562.4. Aer all, it’s
the same asset but two different prices in two different markets.
If one were to execute this transaction well, then a 16 Rupee profit is more or
less guaranteed.
A mutual fund scheme that manages money by mostly chasing such arbitrage
opportunities in the market is called ‘The Arbitrage Fund’.
17.2 – The Arbitrage Fund
While we looked at one type of arbitrage opportunity in the previous section,
in reality, there are many types of arbitrage opportunities in the market.
For instance, one of the most attractive arbitrage opportunity that the mutual
fund looks for is the ‘Spot-Future’ arbitrage, wherein the futures trade at a
price which is significantly away from its fair value when compared to its
underlying price.
In other words, at any given point, the fund is continuously long or short on
the stock in either the equity or futures market.
Did the above line confuse you? Let me elaborate this a bit just to give you
clarity on what happens under the hood of an Arbitrage Fund. Take a look at
the snapshot below –
zerodha.com/varsity
212
213
As of today, i.e. 18th June 2020, the stock price of Maruti is at Rs.5,714.4/- per
share. However, Maruti’s future’s is trading at Rs.5,735.6/-.
The difference between cash and futures is –
5,735.6 – 5,714.4
= 21.2
The difference between cash and futures is called the spread or the basis. One
can capture the spread by setting up an arbitrage. Remember the thumb rule
in arbitrage is to buy the asset in the cheaper market and sell the same asset
in the expensive market. Hence, all one has to do here is –
Buy Maruti @ 5714.4 in the cash market
Sell Maruti Futures (Exping in June)@ 5735.6
It is important to ensure the above transaction is simultaneously executed.
Once you do, you’ve locked in the spread, and it no longer matters where
Maruti trades because the spread of 21.6 is guaranteed.
The key here is the fact that on the expiry day, Maruti in cash and Futures will
trade at a single price (unlike today). The phenomenon is called
‘Cash-Futures Convergence’. So this trade has to be unwound or squared off
or closed on the expiry day.
For example, assume on the expiry day, Maruti trades at 5780 in both the cash
and futures market. The P&L is as follows –
Cash market trade
Buy @ 5714.4
zerodha.com/varsity
213
214
Sell @ 5780.
P&L =5780 – 5714.4
= + 65.6
Here you make a profit of 65.6.
Futures market trade –
Sell @ 5735.6
Buy @ 5780
P&L =5735.6- 5780
= -44.4
Here you make a loss of 44.4.
So, on the one hand, you make a profit of 65.6, and on the other, you lose
44.4, but overall you make 21.2, i.e. 65.6 – 44.4.
The point here is that the spread is locked and you make that no matter what
happens. I’d encourage you to do the same math at few other price points
and see what happens.
Of course, there are other technicalities like rollover, transaction costs,
execution risk, etc. But there is no point getting into these details. All you
need to do if understand what arbitrage is and what happens in an arbitrage
fund.
Have a look at the following; this is an extract of the investment objective of
DSP’s Arbitrage fund –
zerodha.com/varsity
214
215
As you can see, the fund simply states that they aim to generate income
through the cash and derivatives market, without getting into specific
strategy details. Some of the funds also use the term ‘low volatility returns’ in
their scheme description.
A pure arbitrage trade such as the spot-futures arbitrage is inherently less
risky with a predictable outcome; hence it is naturally low volatile.
However, one should not take this at face value. Yes, if the fund is 100%
focused on arbitrage opportunities, the low volatility bit would have been
valid. But then, look at SEBI’s definition of the Arbitrage Fund –
An Arbitrage fund has a minimum of 65% of the funds in Arbitrage strategies,
which implies that they are free to do whatever they want with the balance of
zerodha.com/varsity
215
216
35% of the funds. There is no restriction on that. The usual practice for
Arbitrage funds is to invest the balance 35% in debt funds, and since there is a
restriction on duration, funds usually chase yields. Given this, an arbitrage
fund is not a ‘low volatile’
🙂
Have a look at the portfolio of ICICI Pru’s Arbitrage fund –
Every single equity position is hedged with its futures; these are mostly
arbitrage positions. As we can see, nearly 65% of the exposure is the arbitrage
position. The balance 35% is parked in debt and cash –
zerodha.com/varsity
216
217
The presence of debt papers is what makes the arbitrage funds risky. How
risky may you ask? Well, look at this –
If I’m not wrong, Principal Arbitrage Fund held a concentrated debt position
in DHLF bonds, which DHFL defaulted upon sometime in October 2018.
Naturally, the fund took a hit, and the NAV nose-dived from 11.5 to about
10.9, translating to a run of 5.22%.
zerodha.com/varsity
217
218
In all fairness, 5.22% is not a big hit, but the problem is the time spent on
recovery. It took nearly 1.5 years to recover 5.22% and push the NAV back to
11.5.
This chart teaches us three lessons about the Arbitrage fund –
● As many investors believe, Arbitrage funds are not risk-free. Thanks to
the debt component, there is an element of risk.
● Returns hover in the range of about 5-7%, which can get wiped out in a
single shot if things go wrong.
● Recovery takes time. Hence it is prudent to have a long term
investment horizon while investing in an arbitrage fund.
I hope I’ve not scared you away from investing in an Arbitrage fund
🙂
The good part of an arbitrage fund is that it behaves as a debt fund but gets
taxed as an equity fund. We will have a chapter dedicated to mutual fund
taxation, till then, here is how taxation works (very broadly) –
● Gains from Equity funds sold within 12 months are treated as short
term capital gain, attracts a 15% tax.
● Gains from Equity funds sold aer 12 months are treated as long term
capital gain, attracts a 10% tax, aer an exemption of Rs.1,00,000/-
● Gain from debt funds held for less than 36 months is treated as short
term capital gains, attracts a tax as per the investor’s income tax slab.
● Gain from debt funds held for more than 36 months is treated as long
term capital gains, attracts a 20% tax post indexation.
zerodha.com/varsity
218
219
Given the tax treatment, in my opinion, if you are prepared to take some risk,
then use the Arbitrage fund as a proxy for say low duration or a short duration
fund. The risk and return profile are similar for these funds.
Hence, in my opinion, the real arbitrage in an arbitrage fund is the tax
arbitrage, i.e. it behaves like a debt fund and gets taxed as an equity fund.
Lastly, when you look for an arbitrage fund, it is essential to look at the debt
component of the portfolio. Ensure the fund does not have concentrated debt
positions and also ensure the there are no papers which are below investible
grade.
Also, it is crucial to confirm that the arbitrage fund is not holding any
unhedged equity position because this defeats the purpose of an arbitrage
fund.
Next up is Mutual fund metrics. Stay tuned.
Key takeaways from this chapter
1. Arbitrage funds are hedged position
2. SEBI mandates AMCs to invest a minimum of 65% in arbitrage
strategies
3. Mutual funds usually spend up to 35% in debt
4. Arbitrage funds can be volatile
5. One can consider Arbitrage funds as a proxy for low/short
duration funds
zerodha.com/varsity
219
220
CHAPTER 18
Measuring Mutual Fund Returns 
18.1 – Mutual Fund metrics
By now, I suppose we understand different types of mutual fund categories
and what goes under the hood of each of these funds. While we have not
covered the entire gamut of funds, I think we have covered the most
important funds across both equity and debt.
Probably I must have discussed the Balanced fund as well, not sure why (and
how) I missed that. But I also believe we have laid down a foundation for
structured thinking about funds and their mandates. So I’d request you to
please look upon few balanced fund factsheets, read it along with the SEBI’s
classification and you will understand how the balanced fund works.
Otherwise, you can always drop your queries here, and I’ll be more than
happy to answer them for you.
Anyway, I think we are now one step closer to understand how one can build
a mutual fund portfolio for different financial goals. Before we get into the
building MF portfolios, we must spend time to understand few mutual fund
metrics that help us understand mutual funds better and the ways to
differentiate good funds from the not so good funds.
zerodha.com/varsity
220
221
The metrics that I’m talking about are all mentioned in the Mutual fund
factsheet, and few others are mentioned in the 3rd party website such as
Morningstar and Value research. We need to pick and choose the right set of
metrics to learn and ignore the pointless ones.
Over the next few chapters, we will understand the following metrics that are
usually published by the AMCs for the different schemes that they run –
1. Returns – Absolute, CAGR, XIRR
2. Rolling Returns
3. Expense Ratio
4. Benchmarking
5. Exit load
6. Portfolio turnover ratio
7. Standard Deviation
8. Beta
9. Sharpe Ratio
10.Capture ratios
Of course, along the way, if I feel I’ve missed an important metrics, then I’ll
just add that to the list and discuss the same.
So as you can see, we have a lot to cover, so let’s get started.
18.2 – Measuring MF investment performance
Mutual fund investors oen get confused with the way returns are measured
across investments. Most investors apply the standard return measurement
technique across all types of investment. Doing so leads to wrong return
zerodha.com/varsity
221
222
calculation and therefore, wrong analysis. Return measurement is one of the
key aspects while analyzing a mutual fund. We should start our discussion
with the basic concept of return measurement.
For the sake of this discussion, I’ll assume that you are familiar with the
systematic investment plan or the SIP. I guess the AMCs and the regulators
have managed to do a phenomenal job at conveying the concept of SIP to
every taxpayer in the country (well, all most all).
Hence, I will not spend time to discuss what a SIP is and its massive
advantage for an investor. If you are not familiar with what a SIP is, I will
request you to spend a little time on the internet; there are tons of great
articles with SIP calculators to help you understand what a SIP is and how to
set up one.
zerodha.com/varsity
222
223
However, for the sake of the completeness of this discussion, let me highlight
two popular investments techniques –
Lumpsum investments – In a lumpsum investment, an investor decides to
invest a random amount (based on cash available) at one time. Example – I
get a yearly bonus of Rs.1,00,000/-, of which I decide to invest Rs.75,000/- in a
mutual fund.
Systematic Investment Plan (SIP) – SIP investments requires you to invest a
fixed amount of money on a fixed monthly date in a designated fund. The
investment can be weekly, fortnightly, monthly, quarterly, or even once in 6
months. For example, my very first SIP was set to invest Rs.2,500/- on 5th of
every month in Sundaram Midcap fund. There is no end date to this and can
go on for as long as possible.
The way one measures the return for these two investments is very different.
Most investors take the starting and ending value of their investment and
figure out what the return is. While this is one way to measure returns, this is
not the only way. While measuring return, you need to factor time into
consideration.
For example, if I tell you that I made an 80% return on a certain investment,
what would your first reaction be? I guess you’d say its amazing.
Now, what if said that I made 80% over 15 years? Does it look attractive? I
don’t think so, right? Time adds a very important dimension while we
measure the return. Hence it is always important to consider time.
Given the two types of investment, let us separate these investments into
different time buckets –
zerodha.com/varsity
223
224
The table above helps us understand the different types of investment and
the respective type of return we should calculate. For example, we should
calculate the absolute return for a lumpsum investment which is less than
one year. Likewise, we should look at the XIRR return for a SIP which is older
than a year.
Although for you as a mutual fund investor, you don’t really have to learn how
to calculate the absolute return, CAGR or XIRR because there are tons of free
return calculators available online. However, I think it will just make you a
prudent investor if you take a little time to figure out how this can be done.
Let’s start with the absolute return.
Remember Absolute Return matters only if the investment is less than a year.
It could be a lump sum or a SIP, but as long as the investment is less than a
year, use absolute return.
The calculation is straight forward. Here is an example –
On Jan 1st 2020, I invest Rs.25,000 in a Mutual Fund. On July 7th, the value of
this fund is Rs.30,000/-. What is the return generated?
You should recognise that this is a lump sum invested and is under a year.
The absolute return can be calculated as –
zerodha.com/varsity
224
225
[Ending Value/Beginning Value] – 1
= 30,000/25,000 – 1
= 20%
Let’s take another case. An investor invests Rs.5,000/- every month in a
Mutual Fund. Aer six months, the value of the investment is Rs.35,000/-.
What is the return experience here?
We know that this is a case of SIP investments.
Monthly investment – Rs.5,000/-
Number of months – 6 (less than one year)
Total investment value = 5000 * 6 = Rs.30,000/-
Current value of investment = Rs.35,000/-
We need to apply the absolute value calculation here –
=35,000/30,000 -1
=17%
For SIPs less than one year, we can indeed calculate XIRR, but from my
experience, the most investor will not comprehend this number well as it is
non-intuitive.
Let us revisit the SIP for less than one year a little later to understand why this
may not be the best choice. For now, all you need to know if that if an
investment (lumpsum or SIP) is less than a year, then you have to use
absolute returns.
zerodha.com/varsity
225
226
Next up is the CAGR.
CAGR or the Compounded Annual Growth Rate measures the ‘rate at which
the investment is growing’. Let us take a quick example and deep dive into
this –
I invest Rs.25,000/- on 1st of July 2017 in a certain Mutual Fund. Three years
later, the investment has grown to Rs.40,000/-. What is the return on this
investment?
I’ve kept the question in bold to draw your attention to the question itself. We
will revisit that in a bit.
You should identify that this is a lumpsum investment. Since the period is
more than one year, we need to use the CAGR to calculate the return. The
formula to calculate the CAGR is straight forward –
[Ending Value / Starting Value ]^(1/n) – 1
Where n is time in years. Let us apply this formula –
= [40,000/25,000]^(1/3)-1
= 16.96%
The investment made in this fund has grown at a rate of 16.96% on year on
year basis. Recognise that this is the growth rate of the investment.
The most common confusion for the investor is this –
I invest 25,000, which has grown to 40,000, which means a profit of 15,000.
The return should is about 60%, i.e. 15K profit on 25K investment.
zerodha.com/varsity
226
227
Of course, there is nothing wrong with this calculation. Aer all, this is the
absolute return we are calculating here.
The question, however, is that did you get this 60% in the first, 2nd, or 3rd
year? Was it that you got the entire return in the 1st year and since then the
investment has stayed flat? Or was the return generated in the 3rd year with
the first two years netting zero return?
Of course, one can get into the depths of this and figure the details. But
otherwise, we simply ignore the specifics and take the average growth on
year on year basis. Higher the average the better investment this is.
To put this in perspective, think about a road journey. Let us say you are
travelling from Delhi to Jaipur by car.
If I ask you at what speed you drove your car, will you tell me that your drove
at 80 kmph from Delhi to Gurugram, 110 kmph from Gurugram to Panchgaon,
about 90 kmph between Panchgaon to Neemrana so on and so forth or will
you just tell me that you drove an average speed of 100 kmph?
You won’t give me the split; you will give me average speed.
Likewise, when we look at a multi-year investment period, the years in
between are like the town on a journey. Based on the market conditions (just
like the traffic) investment generates different returns (like driving at a
different speed) during these years. Some years may be positive, and few may
be negative.
zerodha.com/varsity
227
228
As a long term investor, we ignore these yearly variations in returns and take
an average return of the investment, which is what CAGR does. It is the
growth rate of investment.
Now, go back to the initial question, which was intentionally kept in bold. Do
you think that is the right question?
No, the real question to ask should have been – ‘ I invest Rs.25,000/- on 1st of
July 2017 in a certain Mutual Fund. Three years later, the investment has
grown to Rs.40,000/-. What is the growth rate of this investment?
I hope you get the subtle but a the very important distinction on the two
different questions.
Ok, let’s go back to the Delhi and Jaipur example. I know that the average
speed is 100 kmph. At this rate, how much time will you take to reach Ajmer,
which is another 150 km away from Jaipur?
Quite easy – I know the average speed, so you are likely to take about 1 hour
30 mins to reach Ajmer.
On a similar note, I know the investment grew at 16.96%. What is the likely
value of my investment if I let this investment run for another say one year?
Quite easy –
Current value at the end 3rd year = Rs.40,000
Growth Rate – 16.96%
Tenure – 1 yearExpected value = 40,000*(1+16.96%) — > I’m basically
incrementing 40,000 by 16.96%
zerodha.com/varsity
228
229
= Rs.46,784.28/-
Let us twist this a bit, what is the likely investment value if I let this
investment run for three more years?
The formula is
Current value *( 1+ growth rate)^(time in year)
= 40000*(1+16.96%)^(3)
= Rs.64,000/-
This is also called the future value of the investment given a certain growth
rate.
I hope you now appreciate why we need to consider the CAGR and not
absolute return if the investment is more than one year.
One last thing you need to note – Higher the average speed, faster you will
reach your destination. High speed also comes with high risk. Likewise,
higher the CAGR, higher is the rate at which your investment is growing. The
risk too is high in such investments as there could be fears of a crash in the
underlying asset prices.
Anyway, I hope you are now clear about the distinction between absolute
return and CAGR and when to use which one.
We will now shi focus on XIRR, which is applicable when we do SIP over
multiple years.
zerodha.com/varsity
229
230
XIRR stands for Extended Internal Rate of Return. XIRR comes in handy when
you make regular investments in a mutual fund over an extended period.
Hence for SIPs, you need to use XIRR to measure the growth rate.
Assume you invest Rs.5,000/- on 10th of every month in a mutual fund. You
started the investment process in December 2018; you continued to do so till
June 2020. The SIP table looks like this –
So across 19 months, Rs.95,000/- has been invested. The investment amount
is within the bracket to indicate that it is a cash outflow from your bank
account.
zerodha.com/varsity
230
231
Now, as on today, i.e. 10th July 2020, the value of this investment is
Rs.1,10,000/-. Question is what the growth rate is? Of course, you can
calculate the absolute return here. Still, hopefully, by now, you should
recognize that this is a multi-year investment and absolute return does not
serve any purpose.
The traditional CAGR also does not help because there are multiples
investments across multiple periods. However, we still use CAGR, but with
slight modifications. One can say that XIRR is a modified version of CAGR
which accommodates for staggered investments.
The XIRR formula is quite intimidating. I’d suggest you do a Google image
search with ‘XIRR Formula’ as the keyword and you’ll know what I’m referring
too. But luckily we need not have to apply that formula.
MS Excel has an XIRR function that you can use. The function itself is quite
straightforward to use –
zerodha.com/varsity
231
232
If you notice, I’ve included the current value of the investment, I have
highlighted this in bold (above the arrow mark). The number is not in
brackets to indicate the fact that I can get this as positive cash flow into my
bank account if I decide to exit the investment today.
The excel function to calculate XIRR requires two inputs –
1. The series of cash outflows and the current value of the investment
2. The respective dates of cash flow and the date of the current value
zerodha.com/varsity
232
233
Once you feed these inputs, excel does what it is supposed to do and throws
out the XIRR or the growth rate number for you –
As you can see, the growth rate or the XIRR is 18.79%.
Now, if you scroll up, you will see that I mentioned that you could use XIRR for
returns for less than one year, but it’s non-intuitive, therefore its better to
sticks to absolute return.
Let me demonstrate why so. Have a look at this –
zerodha.com/varsity
233
234
This is a SIP of Rs.5,000/- for five months. The total investment is Rs.25,000/-.
Assume the current value on 10th May 2019 is Rs.30,000/-. If I compute the
XIRR for this –
XIRR tells me that the investment has returned 106%. Do you think this is
intuitive? I don’t think so, because a regular MF investor sees a gain of 5,000
over a 25,000 investment. It will be very hard to convince him that the growth
rate of his investment is 106%.
Hence, for this reason, most platforms show the absolute return for SIPs less
than a year, rather than XIRR. In this case, the absolute return is 20%, which is
intuitive for the vast majority.
18.3 – XIRR and CAGR are the same
zerodha.com/varsity
234
235
I would like to discuss one last thing about XIRR and CAGR. I mentioned that
XIRR is a modified version of CAGR. Both XIRR and CAGR serve the same
purpose, i.e. to measure the rate of return over a multi-year period.
It’s just that XIRR comes in handy when we have a SIP kind of investment
situation. Now, if you think about it, then XIRR and CAGR should yield the
same result for a lumpsum investment made over one year.
Let’s take an example –
Investment date – 3rd Jan 2018
Investment amount – Rs.1,00,000/-
Today’s date – 3rd Jan 2020
Current value of investment – Rs.1,25,000/-
The CAGR works out to –
[1,25,000/1,00,000]^(1/2)-1
= 11.8%
If you run the XIRR function on the same set of numbers –
You get the same answer. I hope you get the logic behind XIRR and CAGR.
zerodha.com/varsity
235
236
I’d want you to do an exercise as a follow-up activity. Please visit an AMC
website, or visit coin.zerodha.com, pick a fund and observe how the returns
are mentioned. You should now be in a position to understand what is being
reported and what the returns mean.
Do share your experience by commenting below.
Up next is the rolling returns of a Mutual Fund. Stay tuned.
Key takeaways from this chapter
1. For lumpsum investments less than one year, use absolute
return
2. For SIP investments less than one year, use absolute return
3. For lumpsum investments over a year use CAGR
4. For SIP investments over a year, use XIRR
5. CAGR is the growth rate of an investment
6. XIRR is a modified form of CAGR
7. CAGR and XIRR are same for lumpsum investments over 1 year
zerodha.com/varsity
236
237
CHAPTER 19
Rolling Returns 
19.1 – Point to Point return 
The previous chapter gave us a perspective of how returns are calculated
given the time frame under consideration. So, now if I were to provide you
with the following data point – 
Fund – Aditya Birla Frontline Equity
Starting date – 2nd January 2013
Starting investment value – Rs.1,00,000/-
Starting NAV – 100.83
Ending date – 2nd January 2015
Ending NAV – 161.83 
And asked to find out the returns, you’d probably do it with ease. Let us do
the math – 
Number of units = 1,00,000/ 100.83
= 991.7683
The ending value of investment = 991.7683 * 161.83
= Rs.1,60,497.9
zerodha.com/varsity
237
238
The growth in this lumpsum investment over two years can be calculated by
applying the CAGR formula – 
= [160497.9/100000]^(1/2) – 1
=26.69%. 
Which as would recognize is a phenomenal growth rate. 
Now, let us say you are mighty impressed with your investment, and you start
to propagate the fund. A friend walks up to you asks for the performance, and
you proudly declare the 2-year growth rate is 26.96%. 
Your friend is impressed and decides to invest. 
Now, I want you to think about this for a moment. What do you think is the
fundamental flaw here? 
Did you lie about your investment to your friend? – No
Did you lie or mislead your friend by letting him know the returns you’ve
enjoyed? – No
Well, then what do you think is wrong here?
The growth rate of 26.96% is a massive generalization of two-year growth
rate. When you mentioned this return to your friend would believe that this is
the kind of performance even he is likely to enjoy. 
The 26.96% return is valid when the money is invested on 2nd January 2013
and measure its growth on 2nd January 2015. In other words, the growth rate
is really only for this starting and ending points; it is right for these exact two
dates. It is a very personalized experience. 
zerodha.com/varsity
238
239
If I were to invest and measure the returns on any other dates, then the
profits will be different. 
So, whenever you measure returns or growth between two dates, the value
you calculate is only valid for the two years under consideration. Hence, such
a measurement of returns is also called the ‘Point to point’ return. 
To get an accurate representation of how the two-year return (growth rate)
looks, you need to calculate the ‘Rolling Returns’. 
19.2 – Rolling Return
The rolling return gives us a perspective of how the ‘n years’ return (growth)
has evolved over the last ‘n years’. Sounds confusing? I’m sure it is, so here is
what we will do. 
We will take up an example and figure out the rolling return calculation. I’m
sure understanding the rolling return concept becomes much easier if you
know the math behind. 
zerodha.com/varsity
239
240
By the way, many websites publish the mutual fund’s rolling return, so it is
not essential to remember how to calculate the rolling returns. However, by
knowing the rolling returns math, you will understand the concept of rolling
return quite easily. 
So let us get started. 
I’ve got the historical NAV data of AB Frontline Equity Growth-Direct. The
starting date is from 2nd January 2013, and I’ve got this till 2nd January 2020,
that’s about seven years of data. 
zerodha.com/varsity
240
241
My objective here is to find out the 2-year rolling return for this fund. To do
this, I’ll have to start in 2015. 
I take the NAV on 2nd January 2015 and the NAV 2 years ago, i.e. on 2nd
January 2013 and calculate the return between these two data points. Next, I
move the date by one day, i.e. between 3rd January 2015 and 3rd January
2013, take the NAV for these two dates and calculate the return between
these dates. I’ll again move the date by one day, i.e. 4th January 2015/2013
and calculate the return. 
So on and so forth, such that I have a time series of 2-year return. 
Let us calculate the first rolling return – 
NAV on 2nd January 2013 – 100.83
NAV on 2nd January 2015 – 161.83
Since its two years, we apply CAGR – 
[161.83/100.83]^(1/2)-1
26.69%
The 2nd rolling return in this series would be – 
NAV on 3rd January 2013 – 101.29
NAV on 3rd January 2015 – 161.45
=[161.45/101.29]^(1/2)-1
26.25%
zerodha.com/varsity
241
242
I suppose you get the sequence. I’ve stacked up the data side by side on excel,
and this is how it looks – 
The starting date is 2nd January 2015, right up to 2nd January 2020. 
As you can see, I have the latest date and NAV (shaded in blue). Next to this, I
have the date and NAV for two years ago (shaded in pale yellow). I have
calculated the CAGR against these two NAVs. If I do the CAGR across all the
dates, I get a time series of the daily 2-year return starting from 2nd January
2015. 
Before we proceed, let us look at this statement about rolling return again –
‘Rolling return gives us a perspective of how the ‘n years’ return (growth) has
evolved over the last ‘n years’. Does this sound confusing now?
zerodha.com/varsity
242
243
I hope not ☺ 
Anyway, one minor thing to note here – look at the 2nd data point, I have NAV
for 5th January 2015, but I don’t have the NAV for 5th January 2013, but
instead have the NAV data for 3rd January 2013, which I’ve used. As you may
have guessed, this happens due to the weekend factor. So I’d suggest you
ignore this bit. 
Also, at this point, you should realize that if my objective were to calculate the
1-year rolling return, my starting point would be 2014, and if the objective is
to estimate three years rolling return, then I would start from 2016. 
Now that we have the Rolling Return time series starting from 2015, I can do a
couple of things with the data. To begin with, we can calculate the range of
returns for the time series we have calculated. To estimate the range, we
simply have to calculate the max and min. 
Here is the max – 
zerodha.com/varsity
243
244
And here is the min – 
What does this mean? Well, assume two people invested in the AB Frontline
Equity fund. The lucky person invested on 19th August 2013 and pulled out
his investment on 19th August 2015. This person makes 37.76%. 
The unlucky fellow also invested for two years, but he/she invested on 19th
September 2017 and stayed invested till 19th September 2019. Unfortunately,
this person lost money! 
The point that I’m trying to make is that no two, 2-year returns are the same.
The returns change depending on when you choose to invest and when you
decide to pull out your investment. 
Here is a graph of the rolling 2-year return starting from 2015. 
zerodha.com/varsity
244
245
And as you can see, the two-year returns have ranged from 37% to nearly
-1.0%. If you were to invest for two years, then your return could have been
anywhere within this range. 
To get a perspective of the likely 2-year return, you can take an average of the
rolling returns; this is called the ‘Rolling Return Average’. 
The average is 15.35%. 
So as you can see, the rolling return gives us a lot more insights compared to
a point to point return. 
So the next time you want to invest in a mutual fund, as a part of the analysis,
include these two things – 
1. Identify the period you are interested in investing
2. Find out the historical rolling return min, max, and average for the
period
zerodha.com/varsity
245
246
For example, if I’m looking at investing in a large-cap equity fund for seven
years, I’ll check the historical 7-year rolling return for that particular fund. By
doing so, I will get a perspective of historical return range plus its average. 
In my opinion, this is much better than looking at a point to point return. By
the way, I’ve used 2 years rolling return as an example. If you are looking at
investing in EQ funds, then please consider at least 5 years rolling returns or
higher. 
In the next chapter, let us discuss other MF metrics that matter.
Key takeaways from this chapter
1. Point to point return gives a perspective of the return only for
the two days under consideration 
2. Point to point return should not be taken as a generalization of
return
3. The rolling return gives a better perspective of the return
4. Rolling return average is a better representation of the returns
one can expect
zerodha.com/varsity
246
247
CHAPTER 20
Mutual fund Expense Ratio, Direct, and Regular
plans
20.1 – Expense Ratio
In the last chapter, we discussed the ‘Rolling Returns’, and why rolling returns
offer a better insight into the return pattern compared to a simple point to
point return. Continuing from the previous chapter, we will discuss a few
more important metrics related to mutual funds.
In this chapter, we focus on the expense ratio of a mutual fund. Of course, this
is the 20th chapter in this module, and I suppose we have mentioned
‘expense ratio’, in passing multiples times. However, we never formally
introduced the concept of the expense ratio of a mutual fund. So let us do
that before we proceed.
Think about services like Tata Sky, Netflix, Swiggy, or even Dunzo, these are
all services that you consume fairly regularly (I assume) and therefore you
pay for it. Why would you pay for it? Well, because there is a real cost
involved. For example, a Dunzo executive has to ride his bike to the store, pick
up the item, deliver the same to your house. So there is fuel, labour, tech, and
other expenses involved. Hence we pay a fee to cover for these costs plus a
tiny bit extra which adds to the profit of the company.
zerodha.com/varsity
247
248
Likewise, managing your investments in a Mutual Fund is also a service and
the service is offered by the Asset Management Company (AMC), and
needless to say, you have to pay for it.
The fee mutual fund charges are called, ‘The Total Expense Ratio’ or TER.
Why do the AMCs charge? Well, they have expenses to bear – custodian fees,
Trustee, RTAs, fund managers, admin, brokers, distributors, advertisements,
and of course, as a business, they need to be profitable too.
At this point, there are two possible paths available to us – deep dive into
what, why, how of TER or get a working knowledge of TER.
I prefer we stick to the later. As a Mutual fund investor, all you need to be
aware of is that mutual fund investments are not free, and you have to pay for
it.
However, most of the first time investors would like to believe that mutual
fund investments are free because they never make an explicit payment to an
AMC for the fund management services. In fact, no one explicitly pays an
AMC.
The service fee, i.e. the TER is charged in a very convenient and hassle-free
manner, so much so that you wouldn’t even know you’ve paid for it J.
As a mutual fund investor, all you need to know is –
● How is the fee charged?
● How much is the fee charged?
● Techniques to save on TER.
zerodha.com/varsity
248
249
I’ll use a very simplified example and address these questions. The idea is to
give you rough working knowledge on TER and not the exact math behind.
Assume a certain AMC charges a TER of 1%, i.e. a fee of Rs.1,000/- per year for
every Rs.1,00,000/- invested. Now, this fee is not collected from you the
moment you invest or on a monthly/quarterly/half-yearly or yearly basis. The
fee is collected from you daily, without even you being aware of it.
Let me explain –
Rs.1,000/- is the charge on an annual basis. If you do the math, this works out
to –
1,0000/365
=Rs.2.73/-
So as long as you are invested, Rs.2.73/- is deducted from your funds daily.
The question is, how do they charge and take this money on a daily basis.
Assume the starting NAV of the fund is Rs.10/-. Since you’ve invested
Rs.1,00,000/- you are entitled to receive
= Rs.1,00,000/10
= 10,000 units.
Aer you invest, assume the very next day the fund gains 1%. That means, the
new NAV is –
=10*(1+1%)
= 10.1
zerodha.com/varsity
249
250
And the value of your investment is
= 10.1 * 10,000
= Rs.1,01,000/-
However, the AMC needs Rs.2.73/- from you as a fee. Hence they will deduct
this money from the value of your investment =
Rs.1,01,000/- minus Rs.2.73/-
= Rs.1,00,997.3/-
Or the actual NAV applicable (and declared) is –
= Rs.1,00,997.3 / 10,000
= 10.09973.
Note, the NAV is 10.09973 aer deducting the TER. Before TER the NAV is 10.1.
So the point to note is –
● The NAV that is declared is aer deducting the TER
● The money is collected from you from your investments
● Money is deducted daily
Now in the example, we worked with the assumption that the value of the
investments increases by 1%. Even if the value of the fund decreased, the
fund will still go ahead and charge what they are supposed to charge.
Besides, there are plenty of nuances to TER calculation. For instance, SEBI
has mandated the maximum TER a fund can levy over an Equity and Debt
zerodha.com/varsity
250
251
fund. SEBI has also proposed a maximum TER proportionate to the fund
asset under management for a given scheme. The fund should also consider
the weighted average sum of your investments. So as you can imagine, there
are many subtleties involved.
There are professional ‘fund accounting’ companies which incorporate the
SEBI guidelines and help the AMCs do the math and ascertain the TER on a
weighted average basis. As an investor, I don’t think it is necessary to dwell
into these technicalities as long as you know much you are paying.
Also, when you are selecting a fund for investment, the TER is not a
standalone factor to consider. TER is no doubt important, but just because a
fund is charging say 2%, you should not ignore everything else about the
fund and decide not to invest.
Yes, if you have to shortlist between two funds of the same type including the
return profile, for example, an overnight fund, then it makes sense to look at
the fund with a lower TER and invest in it.
Now, here is a snapshot of the UTI Core Equity fund and the TER it charges –
zerodha.com/varsity
251
252
As you can see, the fund charges 2.11% for Direct plan and 2.39% for the
regular plan.
Now the obvious question – what is the difference between direct and regular
plan and why two different TER for these funds.
20.2 – Direct and Regular plans 
If you are a 90’s kid, growing up in Bangalore, then you’d probably remember
a few ice cream brands – Vadilal, Dollops, Kwality, and Joy. My favourite was
Joy Ice cream, not because it was any different than Vadilal, but because the
Joy Ice cream factory was 500 meters from my house.
It was a small factory with a little retail outlet at the factory’s entrance. At this
factory-owned retail outlet, a choco bar stick was sold at Rs.14/- whereas the
same was sold at Rs.18/- in a shop called ‘Anu stores’, which still is about 1km
away. Whenever my parents felt generous, they would give me some money
to buy ice creams; I’d run to the factory retail shop and pick up a couple of ice
cream sticks for the family. While the kids were happy with the ice cream, my
folks were happy with the savings.
zerodha.com/varsity
252
253
Good old days
🙂
Now, why do you think the factory sold the ice cream at Rs.14/- while Anu
stores sold the same ice cream at Rs.18?
Well, because the owner of Anu stores needed an incentive to sell Joy ice
cream. Without the incentive, why would anyone sell a product, right? That’s
the reason Joy Ice cream as a company would mark up the price to include
the shop owners incentive and sell the choco bar at Rs.18/-.
However, at the factor’s retail outlet, there is no incentive because the Joy Ice
cream as a company would make whatever it had to make by selling the ice
cream directly to the customer at Rs.14/-.
I suppose this is a simple business model to understand.
Same goes with Mutual Funds.
You can choose to buy Mutual Funds in two ways –
zerodha.com/varsity
253
254
● From the AMC directly
● Via a distributor
When you buy a mutual fund directly from the AMC, it is called a ‘Direct’
transaction. The direct transaction is comparable to me buying the ice creme
from the factory owned retail outlet.
However, if you buy a mutual fund from a distributor, then it is comparable to
buying the ice cream from Anu stores.
Now the seller of a regular mutual fund needs an incentive to sell the mutual
fund; hence the AMC marks up the TER and passes the additional TER to the
distributor and the distributor network. Hence, for any given fund, the TER or
the expense ratio for a regular fund will always be higher compared to the
direct fund.
Which leads us to an important point – every mutual fund scheme is available
in two avatars or two plans –
● Direct Plan
● Regular Plan
While everything remains the same, only the TER changes. Have a look at the
snapshot below; I’ve taken this from HDFC AMC website –
zerodha.com/varsity
254
255
As you can see above, we are looking at the HDFC Top 100 Fund (Growth).
There are two variants available to you – Direct and regular. The first in the list
is the direct plan, where they have explicitly mentioned that it is a direct plan.
The second in the list is the regular plan. The AMC has not explicitly
mentioned that it is a regular plan, but is implied.
The TER for both these funds is different. Here is the snapshot –
The TER for Direct is 1.28%, and Regular is 1.78%. The additional TER of 0.5%
in the regular fund is to ensure the distributor is adequately compensated for
selling the Mutual Fund.
It is very important to comprehend the fact that the TER is paid by you, i.e.
the investor to the AMC and therefore the distributor.
When you buy from the AMC directly, there is no distributor, hence no
distributor commission, hence lesser TER. The lesser the TER, the higher the
returns for you.
At this stage, you may be clear about the fact that the TER for regular funds is
higher compared to its direct counterpart. You may have also understood the
fact that the fund is the same – same strategy, same portfolio, same fund
manager, same risk, etc., but the TER or the expense ratio is different.
zerodha.com/varsity
255
256
The difference in TER is mainly to incentivize the Mutual fund agent or the
mutual fund distributor to sell the AMCs fund. You may have a couple of
questions by now –
● Who are these ‘MF agents or distributors’ trying to convince you to buy
regular plans?
● Why would anyone opt for regular funds given that these have higher
TER?
● If the two funds are same, then why is the NAV of direct fund higher
compared to the NAV of the regular fund (refer to the snapshot above)
The MF agents could be your local bank manager or that annoying uncle who
always turns up on Sunday mornings to try to sell some ‘financial scheme’.
The distributor could be an online website as well, where you buy the mutual
fund yourself.
Regardless of who the distributor is, you need to remember that when you
buy a regular MF, you are paying a higher TER fee.
Does that mean buying a regular plan and paying a higher TER is bad?
Well, no.
If you know nothing about Mutual fund investment, and you need help with
this, then you should opt for an advisor who will advise and keep track of
everything on your behalf (markets, MF performance, rebalancing etc.).
Under such a circumstance, it makes sense to buy a regular MF from the
agent to compensate him or her for the advisory work and the continuous
hand holding services.
zerodha.com/varsity
256
257
However, if you are comfortable dealing with Mutual funds (which hopefully
is the case because you are reading this module), then it does not make sense
to opt for a regular fund. You are better off investing in a direct fund and save
on costs.
Hopefully, this explains who these distributors are and why one should opt or
not opt for regular funds.
The last question, i.e. why the NAV of direct funds is higher compared to a
regular fund is perhaps the most asked question.
The confusion is this – the NAV of the regular fund is lesser. Hence the units
are available for a cheaper price, why pay more for the direct fund given the
fact that the NAV for direct funds is higher.
For example, look at the NAVs for HDFC Top 100 fund –
● Direct plan NAV is 460.5
● Regular plan NAV is 438.4
The difference is almost Rs.22/- per unit. It is only natural to want to buy the
regular fund considering it is cheaper.
Well, the problem is in the way we perceive the NAV. If you look at NAV as a
price you pay to acquire the mutual fund, then, yes, the regular fund NAV
looks cheaper, and it seems like a smart decision to pay a lesser amount and
buy the regular plan.
However, if you look at the NAV not as an asset price, but rather as the value
of an asset, then you will soon realise that the regular plan is less valuable
zerodha.com/varsity
257
258
compared to the direct plan. Aer all, the NAV stands for ‘Net Asset Value’, and
not ‘Net Asset price’, I hope you get the subtle difference
🙂
Think of NAV as of the latest value of the asset you’ve acquired.
In the next chapter, we will continue to discuss a few more mutual fund
metrics.
Key takeaways from this chapter
● Investment in Mutual fund is not free; there is a fee applicable.
● The applicable fee is called the ‘Total Expense Ratio’ or simply
the expense ratio
● The TER is expressed as an annual percentage charged
● The TER is charged daily
● The NAV that is declared is posted TER deduction
● For a given fund, TER for the direct plan is lesser compared to
the regular plan
● For a given fund, the NAV for the regular plan is always lesser
compared to the direct plan
zerodha.com/varsity
258
259
CHAPTER 21
Mutual Benchmarking
21.1 – TER savings
I probably should have discussed this in the last chapter itself, but don’t know
why (and how I missed it). While we discussed TER, Direct, and Regular plans,
I should have perhaps given you an indication of how much one can save by
opting for a direct plan. So before we discuss mutual fund benchmarking, lets
quickly address the savings bit. Also, this is my last attempt to convince you
to switch to direct MF investment as opposed to regular MF. 
You can do this little experiment yourself. 
Pick any Mutual fund of your choice. I’ve picked IDFC Core Equity Fund,
Growth. Arbitrarily assume a starting date and a SIP amount, I’ve picked
Rs.10,000/- as the monthly SIP amount, starting from 1st Jan 2014. I further
assumed that the SIP is continued over five years, i.e. till 1st Jan 2020.
I’ve used a standard SIP calculator (I’ve used the one on Moneycontrol) to see
the performance of the SIP in this fund. Here is the result – 
zerodha.com/varsity
259
260
There are a couple of things you will notice here – 
1. The CAGR (or XIRR to be particular) is 8.84%
2. The total amount invested is Rs.7,30,000/- across 73 months. 
3. The total number of units acquired is 20,772.43 
4. The value of the investment aer 73 months of regular investment is
Rs.9,52,000/- 
This is a reasonably standard SIP performance. Now, repeat the same activity
with the same fund, but in the direct option, i.e. IDFC Core Equity Fund,
Direct, Growth. 
zerodha.com/varsity
260
261
Here is how the performance looks like – 
Contract the performance of the direct option with the regular option. I’ve
tabulated this for you so that it’s easy for you to compare – 
zerodha.com/varsity
261
262
In the direct fund, you would have accumulated 19,982 units, slightly lesser
than regular funds. But do recall from the previous chapter, the value of units
in direct funds is always much higher compared to the regular fund. 
As you can see, the investment value in direct is Rs.9,99,527/- versus the value
of Rs.9,52,000/- in the regular fund. 
The difference is Rs.47,527/- or about 6.51% when compared to the initial
investment amount. Where do you think this money is going? 
Well, the money is going to the distributor for having advised you to start a
10,000/- SIP five years ago. 
Now obviously in the direct fund, the distributor does not make this
commission. Hence the returns are higher, this is quite evident when you look
at the XIRR as well – 10.47% Direct Fund XIRR versus Regular plan’s 8.84%. 
Which implies, that every year you end up paying 1.63% of your investment
value as commissions.
Do yourself a favour, and please switch to direct funds
😊

21.2 – Benchmarking and TRI
Moving forward, I guess we need to spend some time to discuss the concept
of ‘Benchmarking’, in mutual funds. 
Benchmarking, in the mutual fund world, is used to measure the
performance of a fund. To put this in perspective, think about an aspiring
athlete, say a runner named ‘X’.
zerodha.com/varsity
262
263
X is practising hard for an upcoming running event. X’s main plan is to not
only win the 100 meters race but also beat ‘Y’, another aspiring runner from
the neighbouring town. 
Now, in the practice run, X clears the 100-meter track in 14.5 seconds. Do you
think he is in a good position to win the race?
It would be hard to say unless we know how much time Y takes to clear the
same track, right? Assume, Y takes 13 seconds. 
Now, who is likely to win the race? Y, right?
We were able to answer (or predict) this because we could benchmark both X
and Y against each other. If we knew the speed of X or Y without knowing the
other person’s running speed, then we couldn’t estimate who is likely to win
the race. 
zerodha.com/varsity
263
264
This is called benchmarking. Benchmarking allows us to measure
performance.
The same goes with Mutual Funds. 
Every mutual fund sets itself against a benchmark and aims to beat that
benchmark in terms of returns generated. 
In the snapshot above, we can see that DSP’s Equity Opportunity Fund,
benchmarks itself against the Niy 250 Index (TRI). 
For example, a large-cap equity fund benchmarks itself against the Niy 50
Index. The idea here being that the large-cap fund should beat the index in
terms of returns generated on any timeframe you choose to measure – it
could be 3, 5 or 10 years. In general – 
1. The MF generates higher returns than the benchmark; then the fund is
said to outperform 
2. The MF generates lower returns compared to the benchmark; then the
fund is said to have under-performed 
zerodha.com/varsity
264
265
To put this in context, assume an Equity fund generates 12% CAGR across
three years while its benchmark, i.e. Niy 50 generates 10.5% for the same
period. In this case, the fund is said to have outperformed. The excess return
with respect to the benchmark is called the ‘Alpha’.
In this case, the Alpha is 1.5% i.e. 12% – 10.5%. 
By the way, in the snapshot above, you must have noticed the ‘TRI’bit. TRI
stands for Total Return Index. The total return index includes and factors in
for dividends as well. Remember, when you buy a stock of a company, there
are two sources of income – 
1. Price appreciation or capital gains
2. Dividend income
Now, think about the regular index chart that all of us check. This chart
captures only the price appreciation of the index. It does not capture the
dividends issued by the index constituents. To get a sense of real returns an
investor earns, one has to factor in for the dividends received by the
company. The total returns index (TRI) captures this. So when we look at the
Niy 50 chart, we are essentially looking at just the price appreciation chart,
but when we are looking at the Niy 50 TRI, we are looking at both price
appreciation, and the dividends received. 
Have a look at a comparison of Niy 50 and Niy 50 TRI, the blue line is TRI
and red is Niy 50 – 
zerodha.com/varsity
265
266
For the same period, TRI has posted an absolute return of 942% while the
Niy 50 has posted 738%. The reason why I’m talking about this to let you
know three things – 
1. For an index, its TRI avatar is always more valuable since it factors in
dividends. 
2. MF’s use TRI as a benchmark; this is a recent phenomenon though.
Earlier, MFs were benchmarking against just the price appreciation
chart. 
3. It’s not easy to beat the TRI index.
😊

Alright, now that we have laid a foundation for our discussion for
benchmarking, let’s take this discussion a bit deeper. 
zerodha.com/varsity
266
267
21.3 – Weights matter
Consider this, there are two mutual fund managers, A & B. 
A manages a large-cap fund and benchmarks his funds with Niy 50 TRI. B
manages an Equity multi opportunity fund and benchmarks his funds against
Niy 500 TRI. 
Which mutual fund manager here do you think will have a tough time beating
their benchmark?
Niy 50 has 50 large-cap stock, while Niy 500 has not only the 50 stocks from
Niy 50 but an additional 450 stocks. 
Intuitively, it feels as if beating the Niy 500 TRI seems like a more
challenging task. Aer all, Niy 500 is diversified, has more stocks, lesser
volatility, and therefore drawdowns are contained. 
Well, but it’s not. The reason for this is interesting. Let me explain this. 
Imagine you have created an imaginary index, call it the ‘High 5’ index. High
five consists of the top 5 stocks across five different sectors. The constituents
of the index are as follows – 
zerodha.com/varsity
267
268
Each stock has a certain weight in the index. The starting value of the index is
1000; the Base Split column shows you the split of 1000 according to the
weight of the individual stocks in the index. 
With this, assume you start your index. Aer a few days, the stock prices have
changed, which means the index value also varies. I’ve randomly assigned
stock price values to the High five index stocks – 
As a virtue of the change in stock price, the individual base values change,
hence the entire index changes. Given the stock price changes, the overall
index value changes, and as you can see, the index changed from 1000
(starting price) to 1,081.72, representing an absolute return of 8.17%. 
Now, let’s not change anything in the high five indexes, let the stocks remain
the same, the reference stock prices will stay the same, and even the starting
value of the index remains the same.
We will only change the weights assigned to individual stocks and see what
happens to the index values. Have a look at the snapshot below – 
zerodha.com/varsity
268
269
As you can see, the weights have changed. For example, initially, the value
assigned to Biocon was 10%, which is not increased to 20%, Bajaj Auto was
changed to 40% from 18%. Likewise for other stocks as well. 
With the change in weights, look at the new base value, that too has changed
from 1,081.72 to 1,056.51. With no shi in stocks, but with a change in
weights, the returns have decreased to 5.65% from 8.17%. 
What does this mean? 
This means that the weights you assign to the stocks within an index matter
the most. Whether you have 50 stocks or 500 stocks in the index is pointless,
what you need to look at it the weights assigned to each stock. 
For example, in Niy 500, the top 10 stock has a weightage of nearly 45%, the
top 25 has a weightage close to 65%, top 50 has nearly 85-90% of the
weightage. 
The rest 450 stocks exist, for the sake of it.
😊

To put this in a more meaningful context, do check the rolling returns of Niy
50 TRI and Niy 500 TRI. 
The chart below is the 10-year rolling return of both Niy 50 TRI and Niy 500
TRI starting from 2005 – 
zerodha.com/varsity
269
270
And the one below is the 5-year rolling return – 
The graphs are generated by my good friend, Shyam from Stockviz. 
It’s remarkable how similar these return/drawdown profiles are. There was
some divergence between Niy 50 and Niy 500 from 2005 to 2007, but that
quickly disappeared. Since then the returns have been relatively similar
zerodha.com/varsity
270
271
across both these indices. Again, indicating the fact that the additional 450
stocks in Niy 500 make very little difference. 
While I’ve not discussed other indices such as Niy 100 or Niy 250, you can
expect something similar. 
So the question is – what difference does it make if the benchmark is Niy 50
TRI or Niy 500 TRI? 
Well, nothing. 
What does this mean to you as a mutual fund investor? I suppose some of you
are reading this may have figured this out already. 
Don’t worry too much about MF benchmarking. You as an investor, should
develop a sense of realistic return expectation from your MF investments.
That realistic return expectation should serve as your benchmark for the
investment and not the one assigned by the AMC. 
Everything else is noise according to me. 
Naturally, this further boils down to setting realistic return expectations in
life. For example, if you’ve predominantly invested in a large-cap fund, then
you should expect large-cap kind of results and not small-cap kind returns.
😊
Having said that, if the fund you’ve invested in is under-performing the index
consistently then that is not a good sign either. Under such circumstances,
you may want to consider a review or even change of fund.
Your ability to analyse a fund and set realistic return expectations from your
investment eventually defines you as an MF investor. The focus over the next
zerodha.com/varsity
271
272
few chapters will be on his, i.e. to identify your personal financial goals, build
an MF portfolio, and set yourself a realistic expectation. 
The next chapter, we will try and conclude our discussion on Mutual fund
metric and then proceed to goals and portfolios. 
Stay tuned.
Key takeaways from this chapter
● Benchmarks help you get a perspective of performance.
● Most mutual funds benchmark themselves against TRI, which
is the total returns index.
● TRI captures the effect of dividends.
● The returns of the index largely depend on the weights
assigned to each of the index constituents.
● TRI returns of Niy 50, and Niy 500 is mostly similar.
● You need to set realistic return expectations and set that as a
benchmark.
zerodha.com/varsity
272
273
CHAPTER 22
Mutual Fund Beta, SD, and Sharpe Ratio
22.1 – Beta
Over the last few chapters, we discussed various attributes of a mutual fund.
We will continue the same in this chapter and focus on key risk measures of a
mutual fund. Risk measures include various attributes such as –
● Beta
● Alpha
● Standard Deviation
● Sharpe Ratio
We will start with the beta.
zerodha.com/varsity
273
274
One of the key attributes of the mutual fund is the ‘beta’ of the fund. The beta
of a mutual fund is the measure of relative risk, expressed as number; Beta
can take any value above or below zero. Beta gives us a perspective of the
relative risk of the mutual fund vis a vis its benchmark.
I’ll not get into the details of how beta is calculated, I’ve done that in the
Future’s module. Here is the link if you are interested to know the math
behind –
https://zerodha.com/varsity/chapter/hedging-futures/
Section 11.5 of this chapter discusses the beta in detail. For this chapter, I’ll
restrict myself to the application of beta and how you need to use this
number. Have a look at the snapshot below –
I’ve captured this from Value research; these attributes belong to Tata
Multicap fund. As you can see, the fund is benchmarked against S&P BSE 500
TRI.
I’ve highlighted the beta of the fund, which is 0.95. Like I mentioned earlier,
beta gives us a measure of the relative risk of the fund. In general,
If the beta of a mutual fund is less than 1, then the fund is perceived as less
risky compared to its benchmark. For example, the Tata Multicap fund has a
zerodha.com/varsity
274
275
beta of 0.95, hence the fund is slightly less risky compared to its benchmark. I
say slightly because it’s very close to 1. This implies, if S&P Sensex 500 falls
by 1%, then Tata Multicap fund is expected to fall by 0.95%.
If the beta was 0.6 or 0.65, the fund is less risk or less volatile compared to its
benchmark. Why? Because if S&P Sensex 500 falls by 1%, then Tata Multicap
fund is expected to fall by only 0.65% and not 0.95%.
This is what I mean by ‘relative risk’; it gives us a perspective of how risky the
fund is compared to its benchmark.
Now, if the beta of a mutual fund is equal to 1, then it means the fund is as
risky as its benchmark. For example, if the benchmark falls by 1%, the fund is
expected to fall by 1%. So both the benchmark and the fund are expected to
have similar risk profiles.
Lastly, if the beta of the fund is higher than 1, it implies that the fund is risker
compared to its benchmark. For instance, a beta of 1.2 suggests that the fund
is 20% riskier compared to its benchmark. If the benchmark falls by 1%, the
fund is expected to fall by 1.2%.
When you are looking at the Beta of a stock or an MF, it is very important to
recognize the fact that the beta is a measure of relative risk, it tells us how
risky the stock or MF is compared to its benchmark. Beta is not an indicator of
the inherent risk of the stock or MF.
To put this in context, think about it this way, Ferrari is faster compared to a
BMW, this comparison is like the beta. We measure the speed of car one
against car two. But does this give you any indication of how fast the Ferrari
is? Not really.
zerodha.com/varsity
275
276
Likewise, while beta gives us a perspective of the relative riskiness of an
asset, it does not give us the absolute or the inherent risk of the asset itself.
By now, you must have a built your perception of beta. Let me ask you this – if
a mutual fund has a high beta, do you think it is bad?
Well, the good, bad, ugly part of beta depends on another metric called the
‘ Alpha ’.
22.2 – Alpha
In the previous chapter, we briefly discussed alpha. We defined alpha as the
excess return of the fund over and above the benchmark returns. Well, that is
true, but we need to make a few small changes to that equation and include
our newly introduced friend, beta. To understand alpha, we need to
understand the concept of ‘Risk-free’ return. The risk-free return is the
maximum return you can generate without taking any risk. By risk I mean –
market risk, credit risk, interest rate risk, and unsystematic risk.
There are two return sources which fit in the above definition – (1) The return
from the savings bank account (2) The fixed deposit return.
Of course, we can argue that the banks too are not safe and come with some
degree of risk. Understandable, but let’s keep that argument aside for this
discussion
😊
Or if you are a stickler for definitions, let us stick to the treasury bills, issued
by the Govt of India. The treasury bills have an implicit sovereign so it's
deemed safe.
zerodha.com/varsity
276
277
The T bill rates as of today are roughly about 3.75%, and let us keep 4% for
convenience.
Alpha is defined as the excess return of the mutual fund over the benchmark
return, on a risk-adjusted basis.
Risk-adjusted basis means we need to –
● Calculate the difference between the mutual fund returns and the
risk-free return
● Calculate the difference between the benchmark return and the
risk-free return, multiply this by the beta
● Take the difference between 1 and 2
Mathematically,
Alpha = (MF Return – risk free return) – (Benchmark return – risk free
return)*Beta
zerodha.com/varsity
277
278
Let's put this in context with an example. Assume a certain fund gives you a
return of 10%, its benchmark returns for the same duration is 7%. The beta of
the fund is 0.75. What do you think of the alpha assuming the risk-free rate is
4%?
Let’s apply the for formula and check –
Alpha = (10%-4%)-(7%-4%)*0.75
= 6% – 2.25%
= 3.75%
As you can see, the alpha is not just the difference between the fund and its
benchmark, which if true, the alpha would have been –
10% – 7%
=3%
But rather, the alpha is 3.75%.
Now, many of you may not find this intuitive. You may question where the
additional 0.75% comes from.
Well, think about it, the fund has managed to generate a 10% return
compared to the Index’s 7% while managing to stay significantly less volatile
(remember beta is just 0.75). Hence we are rewarding the fund for its good
behaviour or less volatile behaviour. Therefore the alpha is 3.75% as opposed
to just 3%.
Now, imagine the same fund, with the same returns, but the beta is 1.3
instead of 0.75. What do you think is the alpha?
zerodha.com/varsity
278
279
By now, you should guess that since the beta is high, the fund gets penalised
for its erratic behaviour. Therefore the alpha should be lower.
Let us see if the numbers agree to this thought.
Alpha = (10%-4%)-(7%-4%)*1.3
= 6% – 3.9%
= 2.1%
See that? While the returns remain the same, thanks to beta, the alpha is
significantly lesser on a risk-adjusted basis.
To conclude, alpha is the excess return of the fund over above the benchmark
returns. Alpha is risk-adjusted. The fund is rewarded if the returns are
generated by keeping a low-risk profile and penalized for being volatile.
By now, you must have realized that volatility plays an important role in
measuring mutual funds performance. Beta is a measure of volatility; it tells
us how risky the fund is when compared to its benchmark. Beta is a relative
risk and does not reveal the fund’s inherent risk.
The inherent risk of a fund is revealed by the ‘Standard Deviation’ of the fund.
22.3 – Standard Deviation (SD)
I’ve explained the concept of ‘Standard Deviation’ in details here –
https://zerodha.com/varsity/chapter/understanding-volatility-part-1/
I’d suggest you go through that entire chapter to understand the concept of
standard deviation and volatility. This will help you not just in your MF
investments, but also investments in stocks.
zerodha.com/varsity
279
280
I’ll take the liberty of skipping the explanation of standard Deviation since it's
already explained. However, if you are in no mood to read an entire chapter
to figure out the standard Deviation, then here is your shortcut –
● The standard deviation of a stock or a mutual fund represents the
riskiness of the stock or the mutual fund
● Standard Deviation is a percentage, expressed as an annualised figure
● Higher the standard Deviation, higher is the volatility of the asset.
Higher the volatility, higher is the risk.
For example, consider these two funds –
I’ve taken the snapshot from Value research. The funds under consideration
are the Axis Small-cap fund and Axis long term equity.
The SD of the small-cap fund is 23.95% while the long term equity is 19.33%,
which implies that the small-cap fund is way riskier compared to the long
term equity fund.
To put this context, if you invest Rs.10,000/- across funds at the same time,
then by the end of the year the profit or loss can be anywhere in this range –
zerodha.com/varsity
280
281
Loss = Investment * (1-SD)
Gains = Investment * (1+SD)
The larger the SD, the larger the possibility of loss or gains.
Generally speaking, the SD for mid and small-cap funds are higher compared
to large-cap stocks.
Do note, volatility or Standard Deviation should not worry you. Markets are
volatile, and equities are volatile, mutual funds are volatile; this is the very
nature of markets. So if you can’t fathom watching your investment see-saw
between gains and loss, then perhaps you should reconsider your investment
decision inequities.
But if you do invest in equities, then you need to learn to manage volatility.
There are two ways to deal with this beast called ‘Volatility’ –
● Diversify smartly (and not over diversify)
● Give your investment time
I think that time is the ultimate antidote against volatility. Give your
investments time, and time will take care of volatility. All along with this
module, I’ve stressed the importance of giving your MF investments time, and
this is the reason why I’ve stressed on it.
Anyway, while at it, check the Alpha and Beta of both these funds. Few
observations –
zerodha.com/varsity
281
282
● The beta of both the funds is sub 1, which means compared to their
benchmark they are relatively less risky. But how risky are they
individually? We can answer this by looking at the SD
● Alpha is a positive number for both the funds, which is a good thing.
The Alpha for Axis small-cap fund is quite impressive. I’d guess this is
because of the low beta factor plus the low risk-free return prevailing in
the economy.
I hope the risk parameters are starting to make sense to you. We will now shi
focus to another parameter called the ‘Sharpe Ratio’.
22.4 – Sharpe Ratio
Sharpe Ratio is one of the most sacred formulas in Finance. It was invented
by Willam F Sharpe, an American Economist in the year in 1966. He was
awarded the Nobel prize in 1990 for his work on the Capital asset pricing
model.
Assume, there are two large-cap funds -Fund A and Fund B. Here is how they
have performed in terms of returns –
Fund A – 14%
Fund B – 16%
Which of the two funds are better? Well, Fund B has a higher return, so
without a doubt, Fund B is a better fund.
Now, consider the following –
zerodha.com/varsity
282
283
Rf is the risk-free return. Along with the fund’s return, I’ve also stated the
standard deviation/volatility/risk of the two funds. Now, which of the two
funds do you think is better?
I guess it gets a little complex to figure out which these two funds are better
given that we have to evaluate them on two parameters, i.e. both the risk and
return.
Ignoring the risk, purely on a return basis, Fund B is better. Ignoring the
return, purely on a risk basis, Fund A is better. But in reality, you cannot
isolate risk and reward; you need to factor in both these and figure out which
of these two are better.
The Sharpe Ratio helps us here. It bundles the concept of risk, reward, and
the risk-free rate and gives us a perspective.
Sharpe ratio = [Fund Return – Risk-Free Return]/Standard Deviation of
the fund
Let's apply the math for Fund A –
= [14% – 6%] / 28%
= 8%/28%
= 0.29
zerodha.com/varsity
283
284
The number tells us that the fund generates 0.29 units of return (over and
above the risk-free return) for every unit of risk undertaken. Naturally, by this
measure, the higher the Sharpe ratio, the better it is as we all want higher
returns for every unit of risk undertaken.
Lets see how this turns out for Fund B –
= [16% – 6% ] / 34%
= 10% / 34%
= 0.29
So it turns out that both the funds are similar in terms of their risk and reward
perspective. And there is no advantage of choosing Fund A over Fund B.
Now, instead of 34% standard deviation, assume Fund B’s standard Deviation
is 18%.
[16% – 6% ] / 18%
= 10% / 18%
= 0.56
In this case, Fund B is a better choice because Fund B generates more return
for every unit of risk undertaken.
Do note, Sharpe ratio considers only price based risk. It does not consider
credit or interest rate risk. Hence, there is no point looking at the Sharpe ratio
for debt funds.
zerodha.com/varsity
284
285
In the next chapter, I’ll discuss the Sortino’s ratio and the Capture ratios and
conclude our discussion on Mutual Fund risk parameters and then shi focus
on building Mutual Fund portfolios.
And I promise I’ll put up the next chapter quickly
😊
Key takeaways from this chapter
● Beta measures the relative risk of the fund compared to its
benchmark
● Higher the beta, higher is the relative risk
● Beta is not an indicator of the inherent risk of the fund
● Alpha is the excess return over and above the benchmark
return on a risk-adjusted basis
● Higher the beta, lower is the alpha and vice versa
● The standard Deviation measures the riskiness of the fund.
Higher the SD, higher is the volatility of the fund
● Share ratio measures the unit of return earned for every unit
of risk undertaken
● Higher the Sharpe ratio, better is the fund.
zerodha.com/varsity
285
286
CHAPTER 23
Sortino and the Capture Ratios
23.1 – The Sortino’s Ratio
In this chapter, we will discuss two other ratios related to the mutual fund
performance/risk measures, i.e. the Sortino Ratio and the Capture Ratios.
These are fairly easy to understand, so we will try to keep this chapter as a
short note.
We discussed the Sharpe Ratio in the previous chapter. The formula, if you
remember looks like this –
Sharpe ratio = [Fund Return – Risk-Free Return]/Standard deviation of the
fund
I want you to think about the denominator. The denominator has ‘Standard
Deviation’, which, as you know, is an assessment of risk.
What sort of risk?
Well, we are talking about the risk of the returns varying from the average
expected returns. Read that line again; we are defining risk as to the variation
(or the variance) from the average expected returns. The variance can be both
positive or negative.
Let me explain, have a look at the image below –
zerodha.com/varsity
286
287
This is the sample daily NAV data for a Mutual fund. I’ve calculated the daily
return for the fund for the time series, and I’ve also calculated the average
daily return for the time series.
The average return is 0.108%.
Further, I calculate the excess return by subtracting the average return from
the actual return. For example, the daily return for 4th August 2020 was
1.23%, the average return is 0.108%.
Hence, Excess Return –
= 1.23% – 0.108%
= 1.13%.
zerodha.com/varsity
287
288
Of course, you square this return to get the variance, from which you further
calculate the standard deviation or the risk.
The point that I want to make here is that when you take the excess return,
you get both positive and negative values. A positive value indicates a profit
and negative value indicates a loss.
Now, let us look at the Sharpe ratio again –
Sharpe ratio = [Fund Return – Risk-Free Return]/Standard deviation of the
fund
By, using the ‘standard deviation’ in the denominator, we try to adjust the
returns per unit of risk. However, the risk contains both positive and negative
returns.
Aer all, we do not want to penalize the fund for a positive return; we need to
scrutinize it for only the negative returns.
The Sortino’s ratio helps in this regard.
The Sortino’s ratio is an improvisation over the Sharpe Ratio, wherein the
denominator has only the negative returns or the ‘downside risk’, is
considered.
Hence, the Sortino’s Ratio is –
= [Fund Return – Risk-Free Return]/Downside Risk
The objective of Sortino’s ratio is to estimate the excess return adjusted for
only the downside risk. Like the Sharpe ratio, higher the Sortino’s ratio, better
it is.
zerodha.com/varsity
288
289
Apart from this one change, there is not much difference between the Sharpe
and Sortino’s Ratio.
23.2 – Capture Ratios
I find the capture ratios very interesting. In my opinion, the capture ratios
overshadow all other metrics and get straight to the point.
Before I discuss these capture ratios, let me tell you a quick story from my
college days.
We were a group of friends in the first year of Engineering; we were young,
restless, and misguided in life.
😊
We were about 8-10 of us, always moved around in a group. Played cricket all
day long, missed classroom sessions, and would sit in the parking lot
spending hours talking about useless things in life. I must agree; it was a lot of
fun
😊
.
So much fun that we at times ignored exams around the corner, to the extent
that most of us would barely manage to get a passing mark.
But there was this one guy in the group who was a little different. He would
spend time with the rest of the gang, hang out, chit chat, play cricket, and go
back home late. He would have all the fun the entire group had. However,
around exam time, he would go back home to study and managed to do
better than the rest of the group. Not that he scored great marks, but he
certainly did better than the rest of us.

zerodha.com/varsity
289
290
And we would all wonder how this guy did it. Sounds typical right? I’m sure
many of you reading this may have come across similar situations in your
college life.
But why am I telling you this story? Well, there is a reason for it.
Please think about this smart friend of mine. While he had 100% of the fun
with the group, he knew when to cut the slack. He knew it was too risky to not
study for the exams.
It may sound weird, but let’s extend this to mutual funds. Imagine this friend
of mine as a mutual fund and the rest of us as the mutual fund’s benchmark.
When the group (or the benchmark) was having fun (or let’s say generating
positive returns), so did this friend of mine(the mutual fund) to his full
capacity.
When it was time to study, the group (benchmark) suffered (think of it as a
negative return), but this friend had good risk management practise, he
scored better than the group.
zerodha.com/varsity
290
291
If we were to summarize his performance, he had max fun, but managed risk
well, and fared slightly better than the rest.
The summary is nothing but the ‘Capture Ratio’.
The capture ratio tells us, for a given period, to what extent did the fund
capture the positive returns of its benchmark and also to what extent it
captured the negative returns from the benchmark.
Here is an example –
This is the capture ratio of HDFC Top 100, Direct, Growth fund on a 3-year
basis. I’ve taken this from Morningstar India website.
The fund has an upside capture ratio of 99, which implies that the fund has
managed to capture 99% of the Index’s up move.
Likewise, the downside capture ratio is 119, which means that the fund has
captured 119% of the downside returns of the Index.
The math behind capture ratio is elementary, but I’ll skip that since as an
investor, you’d not need it.
All I want you to remember is that the upside capture ratio conveys the extent
to which the fund captures all the positive returns of its benchmark. The
downside capture ratio indicates the extent to which the fund captures (or
rather avoided) the negative returns of its benchmark.
zerodha.com/varsity
291
292
Given this, ask yourself, what should be the ideal capture ratio of a mutual
fund? Well, we would want the fund which captures 100% of the upside if not
more. At the same time, we would want the downside capture ratio to be as
low as possible.
Well, this is not easy
😊
A fund will either have a great upside or a great downside capture ratio, but
not both.
A fund either has a great upside capture ratio along with a disappointing
downside capture (like this HDFC fund) or you will find the other way round,
where the upside capture is low and so is the downside capture.
Check this –
This is the capture ratio for the Parag Parikh Long term equity fund on a
3-year basis. While the upside is not impressive at all, the downside capture
ratio is quite impressive.
So the point is that it is always a trade-off. You, as an investor, need to be
clear on this – do you want the fund to be aggressive in chasing returns or do
you want the fund to have a great risk management practice?
I prefer to look at the latter. I like funds which manage the risk better, and I
evaluate this by looking at the consistency of the downside capture ratio,
over many years.
zerodha.com/varsity
292
293
If you look at HDFC Top 100, Regular Growth fund, the downside capture ratio
of 3, 5, and 10 years are 120, 119, and 111 respectively. I like the consistency
in risk management here, and I’d value this far higher than the upside capture
ratio.
By the way, the 3, 5, and 10 year upside capture ratio is 98, 103, 104 for the
same fund, which is not bad at all. Also, it does not matter if you choose to
analyse the upside or downside capture ratio; what matters is the
consistency. Hence it’s important to look at capture ratios across multiple
years.
I usually check the capture ratios on the Morningstar India website. I’m not
sure if these ratios are listed anywhere else.
And with this and everything else we have discussed in the previous chapter, I
hope you’ve got a sense of all the different mutual fund metrics.
The next few chapters will focus on analyzing a mutual fund and building a
mutual fund portfolio for specific financial goals.
Stay tuned.
Key takeaways from this chapter
● Sharpe ratio measures the return per unit of risk by
considering both the positive and negative returns
● Sortino’s modifies the Sharpe ratio and includes just the
downside risk
zerodha.com/varsity
293
294
● Upside capture ratio gives you an estimate of how much of the
Index’s upside the fund has captured
● Downside capture ratio gives you an estimate of how much of
the Index’s downside returns the fund has captured.
● Look for consistency in capture ratio
zerodha.com/varsity
294
295
CHAPTER 24
How to analyse an Equity Mutual Fund
24.1 – Recap
I’d like you to take a moment and reflect upon the last 23 chapters in this
module. I want you to recap the things we have discussed so far mentally.
In a nutshell, here is what we have discussed –
○ Identified that investment is a key part of personal finance
○ Identified various assets which can help us move closer to our
retirement goals or any other financial goals
○ Figured that Mutual funds are the primary financial instrument
which will help us plan our financial goals better
○ Aer establishing the above, we figured that it is important to
focus and learn more about mutual funds
○ We started by understanding what a mutual fund is followed by
the importance of the mutual fact sheet
○ We identified the most popular categories of mutual funds and
discussed the same
○ In the process, we explored various types of funds across both
equity and debt categories
○ Discussed the Index fund
zerodha.com/varsity
295
296
○ Most recently, we discussed the various performance and risk
attributes of mutual funds.
We are now at an interesting junction as we steer our way to the final leg of
this module, i.e. to figure ways to build mutual fund portfolios to help us
achieve various financial goals in our lives.
If you think about it, building a mutual fund portfolio has three parts to it –
1. Identify a financial goal (it can be any) and translate that
financial goal in terms of time and corpus. For example here is a
financial goal – 40 lakh (in today’s terms) for my 10-year-old kid’s
Post-graduation degree in the US. If you break this down, it
translates to a requirement of Rs.40L (adjusted to inflation) in 15
years
2. Identification of funds to help you achieve the financial goal
3. Periodic review and maintenance of the portfolio.
In my view, the first and third point is fairly easy. It’s the 2nd point, i.e. the
actual act of building a portfolio is the tricky bit. If you isolate just the 2nd
point, then you will realize that it is made up three things –
○ Analyze funds, pick the right ones and avoid investing in the bad
ones
○ Figure the portfolio composition – just equity, just debt, a mix of
equity and debt etc.
zerodha.com/varsity
296
297
○ Once the portfolio is identified, figure how much to invest across
each of these funds
Again, in my view, one of the key elements is the fund analysis. You need to
get this right and ensure that you have partnered with the right fund house
and the right fund to help you achieve the financial goal you’ve set aside.
In this chapter, we will discuss a simple technique using which you can
analyze an equity mutual fund. Think of this as a template; you can apply the
same to all equity funds. Of course, there is no right or wrong technique; what
I discuss below is from my own experience. You can develop your template as
you gain more experience with mutual fund investing.
So let us get started.
24.2 – Hygiene check
zerodha.com/varsity
297
298
I’ll pick an Equity mutual fund and set out the process to analyze the fund. As
I mentioned, there is no guided path to analyze a mutual fund. You need to
develop your method to do that. While few investors like to focus heavily on
the fund manager and the quality of stocks the fund manager has picked,
others like to look at only the historical returns.
I like to keep the process simple and stick to things that I’m most concerned
about, i.e. the fund’s ability to manage risk and generate returns.
Alright, so let us get started on fund analysis.
For the sake of this discussion, I’ve picked the Kotak Standard Multi-Cap Fund
(Growth, Regular). Do not treat this as a recommendation of any sort
😊
Remember, direct funds are relatively new and may not have the necessary
historical information; hence we are looking at the regular funds.
The first step is to run a few basic hygiene checks, which includes some of the
good to know information about the fund. Usually, this information is
available in the fund’s fact sheet. The first thing to note is ‘about the fund
itself’, take a look at the snapshot below –
zerodha.com/varsity
298
299
From the note above, I develop an orientation for this fund –
○ It’s a multi-cap fund, which means the fund can invest across
various categorizations.
○ Since it’s a multi-cap fund, I’d expect the fund benchmark itself
against a diversified index, which means Niy 50 TRI may not be
its benchmark
○ I look at the fund’s inception date, in this case, its 11th Sept 2009,
so not a very old fund, but old enough to give me ten years of
history.
○ The fund manager has remained the same, which is fine. If you
belong to the fund manager cult, then you can dig deeper into
who the fund manager is, his background, credentials, track
record etc. I prefer to skip that bit.
I dig further in the fact sheet and get other important information about the
fund –
zerodha.com/varsity
299
300
You can read through the investment objective, you will get valuable insights
from this at times, especially when looking at debt funds. You will figure that
this fund is not restricted to any particular market capitalization. The
investment style grid suggests that the fund can invest across the market and
has a blended approach to growth and value style investing.
If you dig up the portfolio details, you will figure that the fund has the
majority of its investment in large and mid-cap stocks. Given this, the
benchmark for this fund is Niy 200 Total Return Index, which is fine.
I know many MF investors dig into the portfolio details and start to sweat over
why the fund manager has invested ‘x’ amount in Stock A versus ‘y’ amount in
stock B, and in the process, think they carry out ‘a through’ mutual fund
research.
zerodha.com/varsity
300
301
Nitpicking on the Equity fund’s portfolio is not research. I mean, think about
it, if you could figure out which is a good stock and which is not, then you
may as well invest in the stock directly right?
This is as good as sitting on your couch with a tub of popcorn and passing
serious, opinionated comments on how Virat Kohli should bat in International
cricket.
Anyway, the fund has an AUM of Rs.29,500 Cr, which makes it a large fund.
From the AMC perspective, how large is this fund? To figure that out, you need
to look at AMC's overall AUM.
The AUM information is updated on the AMC website regularly. As you can
see, Kotak AMC has an AUM of 1.5L Crore, which makes the standard equity
fund about 18% of the overall AUM.
However, suppose you look at the Equity category. In that case, the AUM is
about 40,000 Crore, which means the Kotak Standard Equity Fund is nearly
72% of the category AUM, which implies that this is one of their flagship funds
for the category.
zerodha.com/varsity
301
302
Why are we digging into this information? Well, we need to know how the
fund is positioned within the AMC to get a perspective. It is also expected that
the AMC would be extra cautious not to mess up their flagship funds.
While at it, do you think funds with large AUM is a problem?. I know many
folks fret about the ‘large AUM’ problem, the rationale being that the fund
manager may find it difficult to manage the funds as the opportunity shrinks.
If the fund flow is steady and the AUM increases gradually over time, then, in
my opinion, it should be ok. However, if there is a drastic increase in AUM,
maybe because of aggressive marketing campaigns, then that could be a
problem and usually results in a slight lag in the performance.
Smaller funds do have an advantage in terms of nimbleness.
Apart from the AUM size, we look at the expense ratio of the fund, direct is at
0.73% and regular is at 1.69%. Not surprising at all
😊
Since you are reading this, I hope you won’t consider regular funds ever again
in your lif e
😊
Moving ahead, I’d like you to look at a few other metrics, these are reported in
the factsheet and also on 3rd party websites like Morningstar and Value
Research.
The snapshot below is from Morningstar.
zerodha.com/varsity
302
303
The fund’s standard deviation (on a 3-year basis) is 20.58%; this suggests the
fund can fluctuate 20.58% up or down over a 3-year basis. The standard
deviation of the category is 21.38%. If you look at it from a risk perspective,
this is nice since it indicates that the fund is slightly better compared to the
category.
If you switch to the 5 and 10 years period, the fund’s SD is 18.39% and
17.42%, while the category’s SD is 19.12% and 18.4% respectively. For now,
this is a good sign as it hints that the fund is good at managing the risk.
Do look at the Sharpe ratio as well. In this case, the Sharpe ratio is negative,
which means either the risk-free return is higher compared to the portfolio’s
return or the portfolio’s expected returns are negative. Either way, this is not
conclusive. Hence we can ignore the Sharpe ratio.
Check the Alpha and the beta of the fund to get a sense of the fund's
performance compared to the category. Of course, you need to do this across
3, 5, and 10 year periods.
Usually, the fund’s hygiene check ends at this point. All that we do in this
stage is to gather a few important ‘good to know’ data points.
zerodha.com/varsity
303
304
24.3 – Rolling returns check
You must have heard the line ‘past performance is not an indicator of the
future performance’, while this is true, there is no better alternative to this. By
studying the past returns and its behaviour, we would at least know what to
expect.
By past returns, I don’t mean 1,3,6 or 12 months returns. In fact, in my
opinion, anything less than three years return is pointless when it comes to
Equity returns. Three years itself is an ok time frame, I’d suggest five years or
higher, but three years is a good start.
We start by looking at the rolling returns. By the way, I hope you know what
rolling returns mean, else I’d suggest you look at the chapter and familiarize
yourself with the same.
I’ll post a series of rolling return snapshots sourced from Rupeevest website.
Hopefully, soon we will have Rolling returns of funds on Coin, our mutual
fund platform.
Here is the three-year rolling return of the Kotak Standard Multi cap fund –
zerodha.com/varsity
304
305
As you can see, I’ve got the 3-year rolling return from Sept 2012. The blue line
is the fund’s three-year rolling return, and the grey is the benchmark’s rolling
return.
The first thing that will catch your attention is the spread between the two
rolling returns. The blue line is consistently above the grey line, indicating
that the fund has delivered better returns compared to its benchmark.
In the three years, the fund has delivered an average return of 15.2% while
the benchmark has delivered 9.87%.
The moment you see such an outperformance, rather than getting excited,
you need to pause and ask yourself – how is this fund pulling this off. Is the
fund taking in more risk compared to its benchmark?
We will figure that out soon.
While the spread between the fund and its benchmark was significant in the
initial years, it has shrunk since mid-2018.
zerodha.com/varsity
305
306
Is the fund losing its sheen? One probable reason for this could be the rapid
rise in its AUM.
Apart from average returns, look at the minimum and maximum returns to
get a perspective on the dispersion of returns.
The fund’s 3-year min and max is -5.19% and +31.2%, and the benchmark’s
min and max are – 6.97% and +23.53% respectively. This fund stands
impressive at this point.
It is important to understand that you are looking at the 3-year data, but just
the 3-years data is not sufficient for analyzing an Equity mutual fund, we need
to look at five and 10-year data as well to get a perspective.
Here is the 5-year rolling return of the fund and we compare that to its
benchmark, the Niy 200 –
Again, on a 5-year basis, the fund’s outperformance to the benchmark is quite
impressive. While the fund’s average is +16.51%, the benchmark is +10.46%.
Note, this is still very similar to the 3-year data.
zerodha.com/varsity
306
307
The dispersion in returns when looked at the minimum and maximum
returns are also quite interesting. The fund’s minimum is still a positive 1.18%
while the benchmark is -2.28%.
However, the spread has narrowed down towards the extreme right, similar
to how it does for the 3-year rolling return.
Lastly, let us see how the fund performs on a 10-year rolling return basis.
Note, there may not be many data points for the 10 years –
The average 10-year rolling return is 12.07% versus the benchmark’s 7.48%,
quite remarkable in my opinion. While the fund’s minimum is 8.59%, the
benchmark’s minimum is 3.79%. On the positive returns side, the fund has
put up an impressive 14.56% versus the benchmark’s 9.67%.
Based on the rolling return data, there are a few apparent things –
● Why is the spread shrinking? Is the fund losing its sheen?
● While the returns are impressive, is this coming at the cost of higher
risk?
zerodha.com/varsity
307
308
The answer to the first question is tricky. There is no fund manager change, so
its unlikely the investment style has changed. Is this because the fund has a
large AUM? Well, this is a tough call to make, but my gut says this could as
well be the reason.
Have a look at the trailing returns as on date –
We can see the fund has underperformed the benchmark on a 3-year basis,
while it is at par on a 5-year basis, and on the 10-year basis, it still has a slight
outperformance.
All in all, it gives me a perspective that the returns were great in the past
years, but will that continue is the question. However, the interesting bit that
the performance has been better than its peers look at the Equity Multi cap
category performance.
As far as the 2nd concern goes, let us focus on the risk metrics of the fund,
perhaps the most crucial bit of our analysis.
24.4 – Risk – Return matrix check
I find the risk-reward matrix published by Morningstar quite useful. Have a
look at this –
zerodha.com/varsity
308
309
I can choose to view this across the 3, 5, and 10 years period. I've been
selected for five years.
The initial bit highlights the fund’s risk versus the category and the fund’s
return versus the category. We know the returns have been great, so no point
looking at it again. Risk versus the category risk is ‘below average’, so that’s
encouraging. For more details, I now look at the matrix.
The Y-axis of this matrix is returned, and the X-axis is the risk. If you have read
Varsity’s Module 9 on ‘Risk Management’, then this matrix is already familiar
to you. If not, all you need to know is that the higher you move on the Y-axis,
higher is the return, and the further you traverse on the X-axis, higher is the
risk.
zerodha.com/varsity
309
310
Anyway, ignore the blue and yellow button and start with the red square,
which is right at the centre of the matrix. The red square belongs to the
benchmark, and from its positioning in the matrix, we can conclude the
benchmark has generated a return of 10% by taking the risk of 19%.
Now, look at the yellow button; it belongs to the category. We can see that the
yellow button is on the same vertical plane as the red square. Hence we can
conclude that the average category risk is similar to that of the benchmark’s
risk, i.e. 19%.
Unfortunately, for 19% risk, the category’s return does not match upto its
benchmark, as it is slightly below the benchmark’s return.
So if you were to choose an investment between the category and its
benchmark, it does not make sense to invest in the category since for similar
risk, the benchmark offers better returns.
What about the fund in perspective?
Well, the fund has a better risk-reward ratio compared to the benchmark. It
seems to have generated similar returns like the benchmark by taking on
lesser risk, which in my opinion is good.
Remember, you are paying the fund manager for active management. Active
management does not necessarily mean generating better than benchmark
return. I think job is well done if the fund manager can generate similar
returns like the benchmark by taking on lesser risk (at a lower cost hopefully).
So on a 5-year mark, this is looking good. Shiing gear to the 10-year window
–
zerodha.com/varsity
310
311
It gets a bit more impressive on a ten-year basis, while the category and
benchmark have a similar risk-return profile (18% risk, 12% return), the fund
has slightly lesser risk and higher return profile.
So at this point, I know that the fund has exhibited a decent track record in
terms of risk and reward profile. As the last step, let us look at the capture
ratios.
24.5 – Capture ratios
We discussed the capture ratios in the previous chapter. I hope you are
familiar with it by now. Here is the capture ratio on a 5-year basis –
zerodha.com/varsity
311
312
Look at the downside capture ratio; the fund has managed to capture 90% of
the fund’s downside, which is good. Again, this a reflection of better risk
management at the fund house.
The capture ratio gets better on a 10-year basis –
The fund has captured almost 100% of the benchmark’s return while
capturing only 87% of the benchmark’s downside returns. Contrast this to the
category.
All in all, our quick analysis shows that Kotak Standard Multi-cap fund is
good. Does that mean you should invest in it right away? Well, we will discuss
this next chapter.
Lastly, I want you to recognize the fact that we have not looked at fund
‘ranking’ given out by agencies. Looking at fund ranking to make an
investment decision is quite useless since you can do a better job yourself.
zerodha.com/varsity
312
313
Key takeaways from this chapter
● You can start the equity mutual fund research with a
basic hygiene check to familiarize yourself with the fund
● Know the size of the AUM, its investment objectives, a bit
about the fund manager, and its benchmark
● Look for the rolling returns of the fund on 3,5 and 10-year
basis.
● Look for the average, minimum, and the maximum
returns to get a sense of the dispersion of the return
● Compare the rolling returns with its benchmark rolling
returns
● If there is excess return, check if this is coming at the cost
of additional risk
● Look for the risk-reward matrix and understand the
risk-reward profile on 5 and 10 years basis
● Check the capture ratios
zerodha.com/varsity
313
314
CHAPTER 25
How to analyse a Debt Mutual Fund?
25.1 – Confused Portfolio
In the previous chapter, we picked up an equity fund (Kotak Standard Multi
cap Fund) and looked at the steps to analyze an Equity fund. The idea was to
highlight the steps involved in analyzing an equity mutual fund. Of course,
towards the end of the previous chapter, we also figured that the fund was
indeed good, especially when it comes to risk management.
The question is – since the fund is good, should you invest in the fund and
include it in your mutual fund portfolio?
While on the face of it, it appears like a no brainer, we've analyzed the fund
across both risks and return parameters. The fund ticks off well on all the
good qualities, so it makes sense to invest.
However, the decision to invest in a fund (and therefore include it in your
portfolio) should not stem from how good or bad the fund is.
The decision to invest in a fund should come from the objective of your
mutual fund portfolio. Remember, the objective serves a financial goal. Now,
for example, if my financial goal is to build an emergency corpus, then
investing in Equity funds may not make sense. So it does not matter how
good the fund is, there is no question of investing.
zerodha.com/varsity
314
315
For many, asking them not to invest in a good mutual fund may come across
a counter-intuitive thought.
To put this in a layman’s context, think about Dolo 650, we all agree that it's a
good paracetamol. Now just because it’s a good tablet, would you take it if
you have knee pain?
No right? It makes sense to take a specific tablet which addresses your knee
pain.
Likewise, an investment should be made only when the portfolio’s objective
and the fund’s risk-reward profile matches. In case, you do not follow this
approach of aligning the two; then you will most likely end up with a
‘confused portfolio’.
Over the next few chapters, we will discuss how to align funds with portfolio
goals, but before we do that, in this chapter lets discuss how to analyze a debt
mutual fund.
zerodha.com/varsity
315
316
25.2 – Risk recap
Like in the previous chapter, in this chapter we will pick a debt mutual fund
and analyze the fund. But before we do that, I’d like to quickly touch upon the
major risks associated with a debt fund.
Credit risk – Remember the debt MF invests its money in debt obligations.
For example, company A wants to borrow 50Cr to fund its operations, decides
to float a 5-year bond by paying an interest of 9%. AMC X decides to invest in
this bond. Assuming things go smoothly, the company gets the funds, and the
AMC gets the interest payment. At the end of 5 years, the company is
expected to repay the principal.
As you can imagine, this is fairly standard practice.
The problem arises if something goes wrong with the company during these
five years and the company is unable to service the interest payment on time.
If things get worse, the company can even throw their hand up in the air and
say, ‘sorry’, no cash to repay the principal or the interest.
All AMCs running debt funds carry this risk, i.e. the risk of default; this is called
the ‘credit risk’. Many funds in the past have taken a hit due to such defaults.
Now, there is a variation to credit risk. Imagine that as on today, everything is
going good for company A, but there is trouble brewing within the company
and the credit rating agencies identify the same. The rating agencies
downgrade the company’s creditworthiness and lower the credit rating from
say AAA to AA. The act of lowering the credit rating itself is a risk; this is called,
‘credit rating risk’.
zerodha.com/varsity
316
317
Interest rate risk – Bonds prices are sensitive to interest rate changes, both
bond prices and interest rates are inversely related. We have discussed this
earlier. A fall in interest rate tends to increase the bond prices (which means
the NAV tends to increase) and increase in interest rate tends to decrease the
bond prices, and therefore the mutual fund’s NAV.
The sensitivity of the bond prices to the interest rate risk is captured by
‘modified duration’ of the bond. Higher the modified duration, higher is the
risk associated with the changes in interest rate. When a debt mutual fund
reports the modified duration, then it is the aggregate modified duration
across the various bonds they hold.
Alright, now that we had a quick refresher on the risks involved, let us focus
our efforts towards analyzing a debt mutual fund.
25.3 – Portfolio check
I’ve mentioned this earlier in this chapter; I’d like to say it again, invest in a
fund not because it is good or spectacular, invest in it because it aligns with
your portfolio goals.
Debt funds allure many investors because of the popular perception that it is
low risk. Oen debt funds get sold as a safe haven for your capital, an
alternative to the bank’s fixed deposit. But it is not.
I’m not saying this to discourage you from investing in a debt fund; I’m
reiterating this to highlight the fact that debt funds are not risk-free. Debt
funds can be volatile and can cause a permanent loss of capital.
zerodha.com/varsity
317
318
Alright, let us move ahead with the analysis part. I’ve picked Mirae Asset
Short Term fund for our analysis. The idea is to lay down a template using
which you can analyze any debt fund of your choice. Much of the analysis in a
debt fund is centred around the risk and the fund’s portfolio, so this will be
very different compared to the equity fund analysis.
The fund itself is relatively new, with its NFO sometime in early 2018, so it
does not have many data points to track, but it is ok.
As the name of fund indicates, this is a short-term fund, meaning the fund will
invest in bonds which have short term maturities ranging between 1 to 3
years.
Have a look at the average maturity graph of the fund, sourced from the AMC
website –
The average maturity of the fund is roughly around 2.5 years, which means
that the fund is susceptible to default risk, credit rating risk, interest rate risk,
and the ‘change in the perception’ of interest rate, risk.
zerodha.com/varsity
318
319
Now, in case any of these risks get triggered, then the fall in NAV will be steep,
and the fund will take time to recover from the losses. The only way to deal
with this is to ensure you stay invested in the fund for a long enough period.
How long?
There are different theories, but I believe that the minimum time you need to
invest in a debt mutual fund should be equal to, at least the average maturity
of the fund. So in this case, if I’m investing in this fund, I’d give it roughly 2.5
to 3 years and not below that.
Similarly, if I’m looking at a Gilt fund whose average maturity is ten years,
then I’d be prepared for a long-haul investment lasting at least ten years.
The investment tenure is something you need to be super clear when
investing in a debt fund.
While we did not pay much attention to the portfolio in an equity portfolio,
we do have to pay attention to the quality of bonds in a debt portfolio.
Here is a quick look at the portfolio allocation (AMC website) –
zerodha.com/varsity
319
320
The fund has 67.31% allocation to corporate bonds, which means to the fund
is highly susceptible to credit risk. Now, how do we figure out that the debt
fund manager is managing the credit risk? Well, we need to check for –
○ The diversification of the fund
○ Exposure to companies – high exposure to a single corporate
entity draws a red flag
○ Credit rating check on the papers held by the fund.
I dug into the portfolio of this fund; you can do the same by visiting Mirae’s
download section –
https://www.miraeassetmf.co.in/mutual-fund-scheme/fixed-income/mirae-a
sset-short-term-fund
Here is the snapshot of a section of the fund’s portfolio –
zerodha.com/varsity
320
321
The fund holds about 56 papers. Straightaway, I can see that the top 3
holdings (3% or more) are all sovereign papers, so there is no concern about
credit risk on single large exposure.
We need to check the exposure at an aggregate level. For example, in the
snapshot above, I can see that the fund has invested 2.44% of its assets in a
7% RIL bond maturing in August 2022.
The fund has also invested 1.64% of the assets in 8.3% RIL paper maturing in
March 2022. So the question is what the total exposure to Reliance Industries
Limited is?
To answer the above, you can quickly add up the numbers from the excel or
check the quick info provided on the AMC’s website –
zerodha.com/varsity
321
322
The fund has a total exposure of 5.56% to Reliance, 5.23% to NHB, and 5.12%
to PFC. In my opinion, these are slightly concentrated bets.
While 56 papers seem good enough, let us see how the fund holds up
compared to the category –
The portfolio aggregates are from Value research online. While the fund has
56 securities, the category average is about 64. The fund has a slightly tighter
portfolio compared to its peers, while the difference is not much in this
particular case, one should be concerned if the difference is large. For
example, I’d have been a bit concerned if the fund held 45 securities against
an industry average of 65.
zerodha.com/varsity
322
323
Moving ahead with our research, we now look at the quality of the papers. We
can develop a perspective of the quality of papers (bonds) held in the
portfolio by looking at the rating profile.
From AMC’s website –
14.41% are sovereign papers, these papers don’t have credit risk, so that’s
one less thing to worry. 66.3%, which is the bulk of the portfolio is AAA. But
do remember the ratings tend to change as papers are constantly evaluated
for credit quality by rating agencies.
A1+ and AA is roughly 8.5%; this is understandable as the debt fund
manager’s chase yields to showcase performance. The question, however, is
to figure if the fund manager is going out of the way to chase yield.
zerodha.com/varsity
323
324
I’ve got this from Value research online. The fund has a higher exposure to
AAA bonds (66%) compared to the category (~45%), which is ok, but this
comes with credit risk. The exposure to Sovereign bonds is less (14.5%)
compared to the category average of about 25%. Exposure to AA bonds is less
compared to the category, and the cash equivalent is higher compared to the
category.
The information above tells me that the fund is open to taking on slightly
higher credit risk, which to me is not a great sign considering this is a short
duration fund. Think about it; this is a short duration fund, people invest in
the fund for parking funds for say 2-3 year perspective with a moderate return
expectation.
So what is the need to take on credit risk? I’d still be ok with the credit risk as
long as there is enough diversification, but the concentrated portfolio is not
very comforting to me.
25.4 – Other checks
zerodha.com/varsity
324
325
Let us go back to the portfolio aggregates –
The modified duration of the fund is 1.97, while the category is 2.34.
Remember, the modified duration is sensitivity to changes in interest rate.
The slightly lower modified duration is attributable to the lower average
maturity of the fund.
The average maturity of the fund is 2.28, while the category’s average is 2.89.
From this, we can deduce that the fund manager is ok with slightly higher
credit risk by placing concentrated bets while at the same time not so ok with
interest rate risk.
The yield to maturity (YTM) of the fund is 4.59 compared to the category’s
5.18. Remember, YTM is the total returns expected based on the assumption
that the bond is held to maturity and the cash flow from coupons are
ploughed back into the bond.
Intuition says that the higher the YTM, the better it is, this is correct. But YTM
can also double up as an indicator of risk when compared to the category’s
YTM.
zerodha.com/varsity
325
326
For example, if the category’s YTM is 6% and the fund is 8%, then it implies
that the fund is taking on additional risk to chase yield.
Ideally, I’d like to see the fund’s YTM match the category’s YTM, and I’m even
ok with slightly lower YTM compared to the category.
I want to look at the fund’s market risk parameters such as the standard
deviation, beta, and alpha to get a sense of how volatile the fund compared
to its benchmark. Ideally, it would help if you looked at it from a 3-year
prospective, but since this fund is new, we won’t get that information.
Lastly, I did look at the AUM of the fund; this is roughly 650Cr. Not a big fund
given its category. When it comes to Debt funds, I’d like to avoid investing in
very small funds or very large funds. In a situation where there is a run on the
AMC and the AMC faces redemption pressure, then a large debt fund will have
issues with debt market liquidity.
On the other hand, a small fund will never negotiate good rates with the
issuers and hence is always a price taker. So it's always good to avoid both
funds with either small or very large AUMs.
So would I invest in this fund? I’d probably hesitate to do so for a couple of
reasons –
○ The fund has a concentrated portfolio
○ Credit risk is higher compared to the category
○ It’s a new fund, and I’m sure there are better alternatives in the
market
○ The fund has a low AUM, understandable since it’s a new fund
zerodha.com/varsity
326
327
If you are thinking why I’ve not looked at standard stuff like fund ranking,
rolling returns, capture ratios, and other things, well, that’s because it does
not matter much for a debt fund.
Before we wrap up this chapters, here are few things for you to note –
○ Investment in debt funds is mainly for capital preservation. Do
not look at returns or chase returns when investing in a debt fund
○ Please do not look at ‘star ratings’, of a debt fund. Usually, a debt
fund is rated high if the returns are high. If a debt fund has a high
return, that means the fund manager is taking on risk to chase
returns.
○ Apart from the standard debt fund risks, keep an eye on the
liquidity risk. We have discussed the liquidity risk here –
https://zerodha.com/varsity/chapter/the-debt-funds-part-4/ . If
both the fund’s AUM and the number of securities fall, then it’s a
red flag and an indicator of liquidity risk
○ SEBI has now mandated the funds to disclose portfolio details on
a fortnightly basis, this is a good move. Do keep an eye on the
portfolio changes
○ Always diversify across AMCs, for example, if you want to invest
in a short term fund, then split your money across two short term
funds from two different AMCs
○ It is best if you avoid investing in a credit risk fund. Credit risk
funds take on credit risk to generate a return. In my opinion, you
should not look at debt funds for returns. Use debt funds to
safeguard capital
zerodha.com/varsity
327
328
○ Debt funds sometimes lend to two different companies but with
the same promoter. Be wary of such funds.
Please pick up debt funds and try to analyze them in the way we have done in
this chapter. I’d suggest you pick up a fund with at least 5-8 years history.
Over the next few chapters, I’ll discuss financial goals and building a mutual
fund portfolio to address the financial goal.
Key takeaways from this chapter
○ The investment in a mutual fund should align with the
financial goal
○ Debt mutual funds carry credit risk, interest risk, and
change in credit rating risk
○ The minimum time duration to invest in a debt fund
should be at least equal to the average maturity of the
fund
○ It is important to analyze the debt fund’s portfolio
○ Higher the exposure to corporate bonds, higher is the
credit risk
zerodha.com/varsity
328
329
○ Sovereign bonds do not carry credit risk but do carry
interest rate risk
○ One should be concerned about large exposure to a
single corporate entity
○ One can look at YTM as the measure of risk
○ It is best to debt funds with large and small AUMs
zerodha.com/varsity
329
330
CHAPTER 26
The Mutual Fund Portfolio
26.1 – Assumptions
We have reached a stage where we have discussed almost everything related
to Mutual funds, leaving us with the last crucial bit, i.e. the mutual fund
portfolio construction. I’ve spent last several days to think through the best
possible way to explain this, and finally concluded that this is a herculean
task
😊
I’ll explain why in a bit, but don’t worry, I will attempt to explain it
😊
Before we proceed, I need to address a few assumptions I’ve made.
When we talk about constructing a mutual fund portfolio or for that matter an
equity portfolio to solve for a financial goal, we make two assumption –
○ We are covered for the risk
○ We are covered for emergency
Before a person can have a portfolio of any sort, these two things should be
in place.
Let me explain what I mean.
zerodha.com/varsity
330
331
Cover for the risk – An individual faces many different kinds of risk in his/her
lifetime. Risk across multiples areas of life – physical health, mental health,
permanent disabilities, a prolonged state of joblessness, broken
relationships, and whatnot.
While it is impossible to anticipate everything and get a cover, an individual
should get a cover for two things in life – loss of life and hospitalization.
Of course, the cover comes in the form of insurance. Term insurance will
ensure that your near and dear ones, your dependents are not financially
burdened aer your passing away.
Health insurance will ensure you don’t spend your life’s earnings to pay for
hospital bills while getting treated for chronic illness.
Given this, you need to estimate the extent your family will be paid off if
unfortunately, you pass away. Similarly, you need to figure out the extent of
health insurance cover you need to get. Topics related to insurance are vast
zerodha.com/varsity
331
332
and have many technicalities. I won’t get into this at this point. But I want you
to be aware that as an individual, the very first step in your ‘personal finance’
journey is to ensure you get cover for these two types of risks.
I want to stress that don’t buy insurance products linked to investment plans.
These are not worth it.
Cover for an emergency – I’m referring to an emergency corpus here, an
emergency corpus to help you navigate your tough times. Tough time could
be a job loss, or it could be as simple as having enough money to replace a
piece of electronic equipment at home or a medical emergency.
I understand medical emergencies are covered by health insurance but don’t
take that for granted. To give you an example, in September 2020, both my
parents were hit by Covid 19. When I took them to the hospital, the hospital
made me pay a certain amount of money for admission and cover the initial
expenses. Of course, I had an insurance cover for both of them, which later
came in handy, but at that moment, I needed ready cash and needed a fairly
large amount.
Or take this, for example – thanks to Covid 19, schools went online, and I
suddenly had to equip the house with a printer and a laptop for my
10-year-old daughter. That was an unplanned financial expense but had to be
done.
Emergencies can come in any form and can come at any time. One has to
have sufficient funds, which is easily available to you when the emergency
strikes. Given this, at the very initial stages of your ‘personal finance’ journey,
I’d advise you to build this emergency corpus.
zerodha.com/varsity
332
333
The question is, how much money is good enough for the emergency corpus?
Different people have different opinions, but I see most of them agree to have
an emergency corpus equivalent to 6 months of expense. For example, if your
monthly expense is 40K, then the emergency corpus should be at least 2.4L.
But I don’t subscribe to the 6-month emergency corpus template.
Each person is different; each family is different. It would help if you sat with
your family, went through different scenarios and identified a corpus amount
good enough to sail your family through these tough times.
Anyway, I will make these two assumptions – that you have the basic
insurance cover and have built an emergency corpus. With these things taken
care of, we will now understand how to build a mutual fund portfolio.
26.2 – Financial Goal
Imagine a newly married couple. Both the husband and wife are young, say in
the late ’20s, and both are working professionals. The couple aspires to buy a
house of their own. Their idea of the home is a 2BHK apartment downtown,
costing roughly 1.5Cr, and they give themselves a ten-year window to achieve
this goal.
Or think of this situation – A 40-year-old working woman wants to accumulate
money to upgrade her car over the next five years. The estimated cost of the
car is 55L.
Or imagine this situation (last one, I promise) – A 21-year-old has just started
working for an MNC. Wants to accumulate 20L in 8 years to fund his/her
post-graduate degree in the UK.
zerodha.com/varsity
333
334
These are all examples of a ‘financial goal’. A financial goal has three specific
attributes –
○ The quantum of funds required
○ The estimated time over which these funds need to be
accumulated
○ The current age of the person
Without these three attributes, a financial goal is incomplete.
For instance, a young working professional who intends to accumulate
‘enough money’ to go to the UK for postgraduate studies in a couple of years
down the line, is not a reasonable financial goal.
With the three random scenarios that I have quoted, you can imagine how
diverse each person’s financial aspirations are. No two families or humans
will have the same requirement (apart from retirement maybe). Financial
goals are extremely diverse and very personal to your situation.
However diverse the situation is, the good thing is that you eventually have to
look at mutual funds to help you solve the situation, well, at least in most
cases.
Of course, there are other financial instruments, but nothing as versatile as
mutual funds (or ETFs).
Given this, there are two ways in which I can help you understand how to
build a mutual fund portfolio to solve for your financial goals –
zerodha.com/varsity
334
335
○ Consider all sorts of life scenarios, build case studies around it,
and stitch together a mutual fund portfolio to solve the given
scenarios. You can then look at these scenarios, identify the one
closest to your situation, and build a similar portfolio for
yourself.
or
○ Help you understand the different attributes of funds from a
portfolio perspective so that you can identify what sort of funds
to pick given the situation.
The difference between the two approaches is like this – assume you like
savoury dishes, so I give you 20 different dishes to try. You taste each one of
these and dishes and finally figure which one to eat fully.
Alternatively, I familiarize you with ten basic savoury ingredients. Once
familiar, you can use these ingredients in the right measure to quickly prepare
a savoury dish to satisfy your taste buds.
I will take the second approach to build a mutual fund portfolio, and I hope
this works out better.
zerodha.com/varsity
335
336
26.3 – Mutual Fund cheat sheet
I’ve prepared this Mutual fund cheat sheet for you. The sheet summarizes all
the key attributes of the different mutual funds we have discussed. Please
click on the image to enlarge and get a better view.
The table is simple, has few basic information –
○ Fund type
○ Category
○ The main constituents of the fund
○ Expected CAGR – as much as I hate it, I’ve included this
😊
○ The minimum holding period – the minimum holding period for
the fund if you were to invest in it. Not that you cannot invest in
the fund and hold it for less than the minimum holding period, it
is just that if you do so, recovering from a drawdown could be
difficult.
○ Financial Goal – The kind of financial goal the fund can be used
for, more on this later.
○ ‘Special remark’ – Things you need to be aware of.
zerodha.com/varsity
336
337
I’d suggest you keep this table handy. This table will help you cra a mutual
fund portfolio for most of the financial goals.
Before we proceed further, we need to understand an important aspect of the
number of funds one should have in a portfolio.
I’ve seen investors with 10-12 mutual funds in their portfolio for a single
financial goal. Usually, their portfolio will contain 3-4 large-cap funds,
another 3-4 mid-cap funds, few random debt funds, and perhaps a hybrid
fund tucked in.
This is a classic example of a messy, directionless, and a pointless portfolio.
Ideally, you need to have non-overlapping mutual funds to avoid
redundancy.
Let me explain, assume you have the following three large-cap funds in your
portfolio –
○ Axis Bluechip fund
○ Mirae Asset Large cap fund
○ Canara Rob Blue chip Equity.
All three funds are good, but does that mean all the three funds should
belong in your portfolio. Take a look at the top 10 holdings across all the
three funds –
zerodha.com/varsity
337
338
As you can see, nearly half the portfolio across all these funds are similar. All
funds hold HDFC Bank to the extent of 10%. If you extend this across all the
portfolio holdings, I’m sure the common overlap would be a much bigger
number. Given this, the performance across these funds also tend to be
similar. The economic/market factors that impact these funds will be similar,
and the volatility will be similar.
Hence, as an in investor, if you buy multiple funds of the same type across
different AMCs, then you need to realize that there is no significant advantage
in you doing so.
Of course, the only argument for having two funds of the same type is AMC
diversification, where you split your money across two different AMCs. You
can probably do this if you worry that one of the AMCs may fold during the
tenure of your investment.
zerodha.com/varsity
338
339
The better way to do this is to see if you can include funds from different AMC,
such as a large-cap fund from HDFC and a mid-cap fund from DSP, where you
diversify across AMCs and market capitalizations.
As an investor, build your portfolio so that the overlap between funds is
minimum. Eliminating overlap is very tough; the idea is to ensure its
minimum. Otherwise, you just end up paying just to get the same exposure
and costs can eat into your returns significantly.
26.4 – Portfolio, by the method of elimination
Let us revisit the scenarios we looked at earlier and see how the table can
cra a mutual fund portfolio.
Case 1 – A newly married couple, aspires to buy an apartment, estimated at
1.5Cr in 10 years. Both of them work, hence can save 30K each, every month.
We have the following data –
1. Savings per month – 30K each
2. Target corpus – 1.5Cr
3. Time available – 10 Years
4. Age – Young can afford to take financial risks in life.
Given this, let us try and arrive at the portfolio by the method of elimination. I
find the elimination technique quite powerful; if not for anything, the
technique helps us avoid the wrong fund for the given financial goal.
zerodha.com/varsity
339
340
Alright, with ten years’ time frame, we know that investing in debt is not
required, so let us eliminate the debt category.
When I say debt is not required, I mean not required as the main investment
fund. Let me get back to this in a bit. Debt has another role to play here.
The focus is clearly on Equity as the category. Within Equity as a category, we
have a list of schemes available, which we need to start eliminating –
○ Large & Midcap – may not work, since most of these ‘Large &
Midcap funds’ are mid-cap stocks anyway.
○ Small-cap funds – These are risky, volatile. Of course, ten years is
a good enough period for this fund, but I’d personally avoid given
the quantum of volatility involved in these funds.
○ Multi cap funds – These are again qazi mid, and small-cap stocks,
may as well stick to a straight forward mid-cap fund.
○ Focused fund – Concentrated bets. Highly dependent on fund
manager skills. If the fund’s investment turns out to be a mistake,
the realization may come in a bit too late.
○ Thematic funds are sector dependent; if the call on sector goes
wrong, the fund will take forever to recover.
○ ELSS funds – Useless one needs to save on taxes as well.
○ Index funds – While this is a great option, somehow, a strict
10-year period may not do justice for these funds. These funds
are best used for hyper long-term financial goals like retirement.
zerodha.com/varsity
340
341
Given the rational, we can eliminate all the above funds, which leaves us with
the following options –
○ Large-cap fund
○ Mid-cap fund
○ Value fund
I’d further eliminate the value fund due to the uncertainties involved in
unlocking value stocks. Hence, the best option for the couple is to invest in a
large-cap and mid-cap stock.
They both can choose a fund each across both these categories and start their
investment journey. Do recall we have discussed how to select an equity
mutual fund in the previous chapters.
The easiest way to invest the funds would be a systematic investment plan
(SIP) in the selected mutual funds every month.
So how do the numbers stack up assuming a CAGR of 10%? Take a look at the
calculation table below. Note, this is a not the entire table, it is just a part for
you to get the idea –
zerodha.com/varsity
341
342
I’ve assumed a CAGR of 10% for both large-cap fund and mid-cap fund, of
course, we can argue endlessly on how conservative/aggressive this return
percentage is, but it would be a waste of time for both of us.
As you can see, the couple accumulates 1.21Crs, which is quite close to the
target funds over the 10-year window. A bank loan can plug in the deficit
(which is not much).
Now, here is another aspect to consider. What if, as and when you approach
the target year, the market starts to fall and you lose the accumulated wealth?
This is a possibility; aer all, no one can time the market.
One way to deal with this is to start to shi the corpus funds to a debt fund as
and when you start approaching the target year. For example, from the 8th
year onwards, they can withdraw the accumulated funds and park it in a debt
fund. There are many different ways to do this –
○ Withdrawal can be made on a monthly/quarterly/semi-annual
basis.
zerodha.com/varsity
342
343
○ The funds withdrawn, can go into an ultra short term fund since
we only hold the funds for 3 years.
The idea here is to protect the corpus from a sequence risk, where in the
market takes a hit as and when the target year approaches.
Of course, this is a rather simplified approach, but I’d like to keep it simple
and not over complicate it.
You may ask if this a ‘fill it, shut it’ approach with no intervention during the
investment tenure. Yes, this is largely a fill it and shut it approach. But once in
a way (like once a year), one should track the fund’s performance and take a
call on continuity.
Apart from that, you need to keep these two points in mind –
○ Use conservative estimates when dealing with returns in
personal finance. If in the end, the returns turn out better, then it
is good for you. Consider yourself lucky.
○ You need to understand that the equity returns are lumpy and
not smooth and steady like a bank FD returns. You may have no
returns for a long time, but the bulk of the returns will come in a
short burst of times. Unfortunately, no one can time this short
burst, hence the need to SIP and give it adequate time.
Let us look at another case and see how elimination would help us build a
Mutual fund portfolio.
zerodha.com/varsity
343
344
Case 2 – A 40-year-old person wants to save 25L over the next eight years for
the kids’ overseas postgraduate degree. Monthly savings available for this
goal is Rs.20,000/-
Since the period is less than ten years, there is no point looking at 100%
equity investment. The plan would largely involve debt, maybe a small equity
portion.
Ok, to begin with, let us keep Equity aside for now and look at the rest of the
funds.
Hybrid funds like the Arbitrage fund may be a decent option, but something
like a balanced fund may not be.
Debt funds are a good option –
○ Liquid funds and overnight funds won’t fit the bill since we are
talking about eight-plus years
○ All funds with Macaulay duration of fewer than two years can be
ignored since these are relatively shorter maturity funds.
○ Money market funds too can be ignored since the investor can
take on a slightly higher degree of risk
○ A short-duration fund is an option
○ Credit risk is risky so that they can be avoided.
○ Corporate bonds fund is an option
○ GILTS won’t fit the bill either.
This leaves us with three good options –
zerodha.com/varsity
344
345
○ Arbitrage Funds
○ Short duration funds
○ Corporate bond funds.
Investment in a corporate bond fund requires a greater degree of
involvement from the investor. If one decides to invest in it, then a regular
review of the scheme’s portfolio is mandatory. If this is not possible, then the
only two options to invest in the short duration fund and the arbitrage fund.
Probably the person can split the investment equally in both these funds.
One thing to note, just because the investment is in a short duration fund and
arbitrage fund, it does not mean that a period review of the fund’s portfolio is
not necessary. Yes, the short duration fund may not need as much scrutiny as
a corporate bond fund, but it does require you to look at, at least once a
quarter. The arbitrage fund too as the portfolio contains a debt portion.
I’ll spare you the maths here, but if you assume a 7% CAGR, the target funds
can be accumulated over the given timeframe.
Since this is anyway a longish tenure, i.e. 8 years, one can also consider a little
equity exposure. Maybe 20-25% of the monthly SIP can go into a large-cap
fund.
Let us take up one last case – You’ve received a lump sum amount, say Rs.50L
from the sale of an asset, maybe real estate. You want to use this amount and
start a retirement corpus. However, you are worried about the current state of
markets and fear that the current market level is unstainable.
zerodha.com/varsity
345
346
Retirement is a hyper long-term financial goal. By hyper long term, I mean 20
plus years but may vary based on your current age.
Here is a plan assuming you are not comfortable investing the lump sum right
away.
○ Invest the lump sum in a fund which offers capital protection (to
the best possible extent)
○ Withdraw chunks of it every month and invest that into the
designated fund for retirement
○ Continue doing do so till you deploy the entire capital
In this case, you can decide to invest 50L over 3/6/12 months, based on your
comfort.
Assuming, six months, then every month you will invest –
5,000,000/6
= 83.3K.
The question is, what is the choice of funds for such a plan of action.
○ We need a carrier fund , which will hold the capital, provide
adequate capital protection over the next six months.
○ The only funds which fulfil the purpose of the carrier funds are –
the overnight or liquid fund.
zerodha.com/varsity
346
347
○ Identify a target fund for retirement. Recall, retirement is a hyper
long-term financial goal so the funds you pick for this purpose
should fit this bill
○ The best funds for retirement (in my opinion) are Index funds,
large-cap funds, or just a balanced fund.
So the set up here would look like this –
○ Park the entire 50L in a liquid fund to redeem the entire amount
over six months
○ Redeem 83.3K every month from the liquid fund over the next six
months
○ Invest the funds redeemed funds into the retirement fund – say a
Balanced Fund and a Midcap fund. Or an Index fund and a
mid-cap fund.
○ If you are choosing two funds, the funds can be split equally.
Do remember, once you invest in these funds, this is largely on autopilot
mode with no frequent intervention required from your end. However, you
may need to look at the following –
○ Yearly review of performance – ensure your fund is not lagging its
peers and behaving more volatile compared to the rest of the
category
zerodha.com/varsity
347
348
○ You may want to rebalance based on your risk appetite, wherein
you book some profits from the equity funds and deploy the
same in debt funds.
Apart from the above two, you are fairly set. Please don’t attempt anything
else, and let the market do what it is supposed to do.
I’ll stop the case studies here since it is impossible to cover all sorts of cases.
But I hope this chapter has given you a good starting point for designing your
mutual fund portfolio.
I’d love to dig deeper on this topic of goal-based investing, but at this stage,
I’m not sure if I will take that route. If you do want me to do that, share your
comments below.
Over the next 2 or 3 chapters, I’d like to discuss the Sovereign gold bonds
(SGB), NPS, and perhaps a bit about asset allocation, and wrap up this
module.
Key takeaways from this chapter
○ The first step in personal finance is to ensure you have
health and term insurance
○ 2nd most important aspect is to ensure you have an
emergency corpus
zerodha.com/varsity
348
349
○ The financial goal is defined by the amount of corpus
required and the time frame available to accumulate the
corpus
○ One of the easier ways to build a mutual fund portfolio is
by using the method of elimination
○ Always use a conservative approach and tone down your
return expectations
○ Try and avoid having multiple funds of the same
subcategory, have a minimum non-overlapping portfolio
instead
○ A common goal for all us to have a retirement corpus
○ Once a portfolio is set, a yearly review of the funds is
more than sufficient
○ Do not over complicate mutual fund portfolio construct
zerodha.com/varsity
349
350
CHAPTER 27
Smart-beta Funds
27.1 – Overview
Before we get started with this chapter, I need to inform you that this chapter
(and the chapter on Index funds) is not authored by me (Karthik). These two
chapters are authored by Bhuvan, a brilliant colleague of mine, who is quite
knowledgeable on this topic and asset management in general.
In fact, the next chapter on asset allocation will be authored by another
gentleman (and a good friend of mine) from the industry who is super
knowledgeable about everything related to market finance.
I’d like to thank these folks for helping me with this module and sharing their
wisdom with all of us.
Read on.
—
In chapter 6 & 7 , we discussed the basics of a mutual fund and how it works.
In chapter 16 , we specifically talked about index funds. I had mentioned that
we would discuss a relatively new category of funds in the Indian context
called smart-beta funds and ETFs, but this got delayed. The idea with this
chapter is to give you a working knowledge of these funds.
zerodha.com/varsity
350
351
The term smart-beta evokes a lot of strong opinions among investment
professionals. Although it sounds fancy, it largely means nothing and is
largely a marketing term. Smart-beta broadly speaking is a catch-all term for
factor investing and any weighting methodology which deviates from
traditional market-cap weighting. If you remember from the previous chapter
on index funds, an index fund tracks a market-cap-weighted benchmark like a
Niy 50, Niy 500 etc.
Just as a refresher, a market-cap-weighted index weights stocks based on
their market cap (outstanding shares X current price). Higher the market cap,
higher the weight in the index. Niy 50 is an example.
Similarly, there are ETFs based on fundamentally weighted indices. For
example, an index that weights stocks based on earnings, a combination of
fundamental metrics such as earnings, dividends, profitability etc.
27. 2 – What is a factor; you might be wondering?
A factor is a broad, persistent driver of the returns of a stock. Put another way,
in factor investing, you target securities that exhibit a particular characteristic
that drives their returns. Remember this definition, and we’ll come back to
this in a bit. But before we do, it is also important to understand a little bit of
history for context.
Factor investing results from continued academic research starting with the
Capital asset pricing model (CAPM), efficient markets hypothesis (EMH) etc.
CAPM states that a single factor, the market factor or beta, drives returns, but
this didn’t stick. Factor investing became mainstream when Eugene Fama
zerodha.com/varsity
351
352
and Kenneth French published their landmark research paper The
Cross-Section of Expected Stock Returns.
In the paper, Fama and French added two more factors – Value and size and
market factor. This meant that there were other drivers of stock returns than
just market risk; this was what came to be known as the Fama French 3-factor
model. In 2014 this became a 5-factor model when two new factors—
profitability and investment factors were added.
Apart from the famous Fama French factors, other factors like Momentum
and Low Volatility also have been discovered. What do these factors mean?
Here’s a niy explanation from Robeco of the most commonly used factors:
zerodha.com/varsity
352
Value
The tendency of inexpensive securities, relative to their
fundamentals, to outperform over the longer term.
Mome
ntum
The tendency of securities that have performed well in the recent
past to continue to perform well, and for securities that have
performed poorly to continue to perform poorly.
Low
risk
Refers to the observation that low-risk securities tend to earn
higher risk-adjusted returns than high-risk securities.
353
So, investors look for stocks that exhibit these traits and then build these
factor portfolios.
How have factors performed in India? There isn’t much data in India, and
most of the factor or smart beta indices are pretty new. But here’s how
momentum, quality, and low volatility have performed vs the Niy 50 and
500.
zerodha.com/varsity
353
Qualit
y
The tendency of securities issued by sound and profitable
companies to outperform those issued by less sound and profitable
companies, and the market as a whole.
Size
The tendency of bonds issued by companies with little debt
outstanding and small-capitalization stocks to outperform the
market.
354
The charts are from Shyam who runs Stockviz .
Impressive returns all around. Low volatility, in particular, has been
impressive with shallow drawdowns. Niy Alpha, a proxy for momentum has
been impressive but comes with sharp drawdowns.
Here are the annual returns for a more granular look.
The charts are from Shyam who runs Stockviz .
zerodha.com/varsity
354
355
But, it’s also important to understand why these factor premiums exist in the
first place. There are broadly 3 reasons market practitioners and academics
propose:
Risk-based : Factor premiums exist because investors need to be
compensated for the additional risk they bear. For example, academic
literature shows that value stocks, i.e. cheap stocks, tend to outperform
expensive stocks over the long run. But cheap stocks more oen than not
tend to be cheaper because they have a higher chance of going bankrupt. Or
in the case of an economic downturn, value stocks will be the first ones to go
out of business.
Behavioural-based: This camp believes that these factor premiums exist
because of behavioural biases among investors. For example, this camp says
that the value premium exists because investors chase glamorous growth
stocks and ignore cheap stocks, i.e. your value stocks. Similarly, this camp
believes that the momentum effect exists because of investor under-reaction
and overreaction. They under-react to good news or good earnings and then
over-react, causing a feedback loop which pushes prices higher.
Structural issues: This camp says that factor premiums exist because of
structural reasons like illiquidity, high transaction costs, difficulty in applying
leverage etc.
Like with all things, it’s not just one thing, and it might be a combination of
multiple reasons. Humans are complex beings, and the markets are complex
adaptive systems. It would be unwise to conclude anything else.
zerodha.com/varsity
355
356
At this point, you might have ignored everything I just wrote aer the charts
because the returns look so good. But, not so fast. In investing there are no
free lunches except for diversification probably.
27.3 – Smart-beta funds in India
Smart beta or factor funds are relatively new in India. The first smart beta
ETFs were just launched about 4-5 years back. There are a few quant funds
from Reliance, Tata, and DSP. But unlike a smart beta ETF, the methodologies
of these funds aren’t fully transparent.
Having said that, these are just index returns, and real-life trading
performance is always different due to costs, slippage, changes in market
microstructure etc. Our markets have evolved a lot since 2005 from when
these indices start. You could argue that they have become a lot efficient.
Given that we are just seeing the launch of the first few smart-beta funds in
just the last few years, we don’t have a lot of live trading data yet. But here’s
how quality, value, and low volatility ETFs have performed vs Niybees
zerodha.com/varsity
356
357
This data is from 2019, and it’s not a lot to conclude, but it is evident that not
all factors perform all the time.
Factor or smart beta ETFs have a longer trading record in the US and here’s
how some of the popular smart ETFs have performed vs the S&P 500. Of
course, this chart is subject to starting point bias because this was the point
from which continuous trading data was available for all major factor ETFs
but didn’t change the conclusion.
As you can see, factors are cyclical and can go a long time underperforming
simple broad market index funds. Here’s data in the Indian context, notice
how the top factors keep changing.
zerodha.com/varsity
357
358
ICICI Quant Fund presentation
Value (IWD) has underperformed the S&P 500, dominated by growth stocks
for over a decade now. Mind you; I’m using these US examples since the data
is readily available and the Indian markets aren’t the same as the US.
zerodha.com/varsity
358
359
Now imagine if you had put 100% of your money in value, not that many
would. Now bear in mind that, no two factors ETFs are the same. Each factor
can be defined and implemented in 100 different ways. For example, as
defined in Fama and French’s paper, the value was the price to book, but each
value ETF or index has a different methodology such as price to sales,
EBIT/TEV, forward earnings, or a mix of value metrics. This leads to a wide
dispersion in returns among the same or similar funds.
27.4 – Do smart-beta funds work?
There are broadly speaking two views of thought. On the sceptical side, many
people view factors as backtests and that they are a result of data mining that
doesn’t work as advertised. Then, there are a few who believe that they might
have worked in the past but don’t anymore.
On the other side, you have true believers in factors. Several asset
management companies manage 100s of billions on factor strategies.
Dimensional Fund Advisors (DFA) was most notable among them, which was
zerodha.com/varsity
359
360
founded by David Booth and managed over $500 billion in assets in various
factor strategies. David Booth was a student of Eugene Fama at the Chicago
School of Business. Fama also serves on the board of DFA.
I personally think that factors do work overtime, but the factor premiums
aren’t static; they ebb and flow over time. You have to bear a lot of pain for
that premium and have really long-term horizons to harvest that premium.
Having said that investors also must be cognizant that the markets have
indeed changed and keep changing over time. In the 90s, when the first
factors were discovered, you could argue that the markets still had many
inefficiencies and retail investors still made up a good chunk of the markets.
Today, everybody has all the data at the click of a button on smartphones,
and there are millions of CFA holders, hedge funds that manage trillions of
dollars constantly seeking new inefficiencies. Even in India, mutual funds,
PMS’, AIFs, HFT traders, institutions have become dominant players in the
markets.
Have the factors been arbitraged away? Unlikely, investors shouldn’t just look
at past returns of indices and backtests and have the same expectations. The
probabilities are the premiums might not be as large as they seem.
The proliferation of data and computing power has also led to 100s of new
factors resulting from data mining. If you look at the backtests of some of
these factors, they look amazing, but they are spurious at the end of the day.
Practitioners and academics have termed this as the “factor zoo” .
zerodha.com/varsity
360
361
27.5 – Should you invest in smart-beta funds?
I do not think investing 100% of your equity allocation in smart-beta funds is
a good idea. Nor do I think that smart-beta funds should be viewed as
replacements for index funds or good diversified active funds that perform
consistently – emphasis on good and consistent.
But we’ve seen in the previous chapter on index funds that a vast majority of
active funds don’t beat their benchmarks. I do think smart-beta funds are a
good replacement for poorly managed discretionary active funds. The bulk of
your equity allocation should be good consistent diversified active equity
funds or in index funds. And then you can invest in smart-beta funds for that
chance of extra returns.
But do remember, factors can go a long time underperforming simple index
funds. These premiums are also sensitive to the amount of money chasing
them. So, as more such funds are launched in India, and more money flows
into them, the factor premiums might not always be as large as they once
were. Remember, there are no free lunches in the markets, and every choice
you make as an investor comes with trade-offs. You need to endure that pain
if you hope to harvest those additional returns, say, a simple index fund.
One solution is to diversify among factors, there are multi-factors funds that
invest in multiple factors, but we don’t have many of those in India yet. ICICI
alpha low volatility ETF, which was recently launched, combines two
momentum and low volatility. Similarly, DSP Quant Fund and the likes of Tata
Quant Fund also are multi-factor funds. But their methodologies aren’t as
transparent as index-based smart beta ETFs.
zerodha.com/varsity
361
362
We see AMCs slowly launching these funds, and hopefully, we’ll have more
choices in the next couple of years.
Key Takeaways from this Chapter
● The idea with this chapter was to give you a working
understanding of smart beta and factor investing. I think you
need to dive deeper if you wish to allocate to these funds.
There are some amazing resources on factor investing, and a
cursory Google will surface them. Please dive deeper before
investing in these funds.
● Smart beta is just a marketing term. There is no smart beta or
dumb beta.
● Smart-beta funds are nothing but factor funds or funds that
have alternatively weighted indices unlike Niy 50 which is
market-cap-weighted
● The live performance of factor funds can be different than the
indices.
● Factors can be highly cyclical, and individual factors can
underperform simple diversified funds or index funds for
decades.
● If you want to invest in factor funds, diversification among
factors is an important consideration.
zerodha.com/varsity
362
363
CHAPTER 28
Asset Allocation, An Introduction
Dear Readers, 
Like this previous chapter, this chapter too is a guest chapter. We are honoured
to have this super important chapter authored by Shyam , who runs Stockviz .
We are grateful to Shyam for sharing his wisdom on this topic with us. We hope
he can contribute more to Varsity, and enrich Varsity’s content
🙂
Happy reading!
Karthik Rangappa. 
28.1 – Asset Allocation, an Introduction
An asset is anything that you own. A liability is something that you owe.
An asset can be anything: livestock, gold, stocks, bonds, collectables, art,
copyrights, trademarks, and so and so forth.
zerodha.com/varsity
363
364
Some assets (bonds, for example) throw-off cash (pay interest) when you own
them, some (art, for example) don’t. The basic purpose of owning an asset is
to transmit wealth through time.
Time value of money
Money, in the form of currency, is designed to depreciate over time. Central
Banks call this rate of depreciation their “inflation target.” For example, when
the US Fed says that they are targeting 2% inflation, the purchasing power of
a $100 note will be $98 next year. In India, RBI’s goal is to manage inflation
between 4% and 6%. We ended the year 2020 with an inflation rate of close to
7%. Clearly, stuffing money under a mattress is a loser’s game. So, how do
you preserve the purchasing power of your wealth? You buy assets , of course.
Different type of assets
zerodha.com/varsity
364
365
Precious Metals
Since the dawn of civilization, people have been trying to find cost-effective
ways to store, transport and exchange wealth. It took a while for us to zero-in
on gold and silver as a medium of exchange and a store of wealth:
● They are rare, ensuring a limited supply.
● Takes work to mine, purify, mould, etc. This puts a floor on additional
supply.
● Easily understood, measured and assayed.
● Sufficiently dense so that small quantities representing large notional
values can be moved around easily.
So, it shouldn’t come to a surprise that most people still think of gold (and
precious metals, in general) as a must-have asset. Investors instinctively reach
zerodha.com/varsity
365
366
for gold when other assets are facing stress. And for savers in countries with a
long history of socialism with their governments trying to confiscate property
and inflate away their currencies, gold forms a large part of their savings.
Real-estate
Broadly, real-estate investing covers land speculation, rental-housing and
commercial property. They each have their unique characteristics and scale
requirements. Each piece of real-estate is different – they are not fungible,
like precious metals, nor can they be transported. So every real-estate
investor’s experience will be different.
Collectables
Well, known pieces of art, baseball cards, stamps, rare-coins etc. are known
to hold their value through time. A mature ecosystem of services that curate,
authenticate, promote and store collectables exists to make investing in them
relatively painless.
Over the last decade or so, we have seen the rise of digital collectables, like
bitcoin. They have the added benefit of being infinitely divisible. To use the
bitcoin example, even though a single bitcoin is currently worth north of
$40,000, a newbie can buy just $10 worth of it.
Financial Assets
Assets that can be traded on an exchange, like stocks, bonds, commodities,
etc. benefit from standardization and the uniform application of laws and
regulations. Standardization ensures that investors always get what they paid
zerodha.com/varsity
366
367
for and regulations ensure that the exchange doesn’t favour one investor over
another while disseminating information, clearing trades, etc.
The most liquid and popular of these assets are stocks/equities, the largest
are bonds/fixed-income. Commodities come a close third. Overlaid on top of
these are derivatives – instruments that derive their value from an underlying
stock/bond/commodity – that are now a bigger market than the assets
themselves.
Since the 1980s, the number of different asset types traded on electronic
exchanges has increased by leaps and bounds. Assets that were once illiquid
because of physical delivery requirements or geographical barriers have seen
an explosion of liquidity as they are now traded through derivatives and ETFs.
28.2 – Allocation
The act of splitting one’s savings between the different types of assets
described above is called “asset allocation.”
Prediction is impossible
If you knew which of the assets discussed above would give the best returns,
then you could just put all your money in that single asset. But unfortunately,
no one knows the answer to that question.
For example, take US and Indian stocks. For the decade between 2001 and
2011, Indian stocks massively out-performed US stocks.
zerodha.com/varsity
367
368
But performance completely inverted in the next decade.
Who knows what is going to happen in the next 10 years?
zerodha.com/varsity
368
369
Once prices start moving, narratives get built around why they are justified
and persist forever. The longer the price moves, the stronger the narratives.
Remember “India shining,” “secular stagnation,” “home prices always go up?”
The only way to protect yourself from decades of underperformance without
having to predict is to buy a little bit of all assets.
28.3 – Sequence Risk
An average investor rarely sees average returns.
Markets have been around for centuries, but an investment’s lifespan is not
more than a few decades. This leads to all sorts of misconceptions regarding
averages and risk capacity.
Investor : On average, over the last 20 years, the NIFTY has given a CAGR of
10%. So, if I invest Rs 1 lakh for 5 years, I should get at least Rs 1.61 lakhs, no?
Me : No. Consider yourself lucky if you don’t lose money.
Investor : But it has given negative returns only 4 years out of 10. I can survive
2 years of negative returns.
Me : Let me tell you something about sequence risk. Sequence risk means that
it is possible that you could have all of those negative 4 years during the 5
year period that you have invested.
zerodha.com/varsity
369
370
Most investors don’t realize that while averages may be true in the aggregate,
they may not survive long enough in the market for their personal experience
to match up with the statistics.
A simple way to avoid this risk is to invest in a basket of assets whose returns
are not correlated to each other.
28.4 – Diversification vs Diworsification

A basket with chicken eggs, turkey eggs, goose eggs, quail eggs, pheasant
eggs and emu eggs is theoretically diversified but practically useless when
the basket is dropped.
To create a diversified portfolio, you need first to understand the drivers
behind each asset class’s returns and how they interact with each other.
Vectors of diversification
zerodha.com/varsity
370
371
Different vectors drive returns of different assets and the correlations
between them. A well-diversified portfolio covers these different vectors with
minimal overlap. Some examples below.
Currency exchange rates
Gold is priced in international markets, so its future price movements in India
are both a function of global demand and USDINR exchange rate.
Market composition
“old economy” stocks mostly dominate indian equity markets while that of
America’s is dominated by tech (“new economy”) stocks. So they require
separate allocations in a portfolio even though they are “stocks.”
Flows during panics
zerodha.com/varsity
371
372
American bonds are “safe-haven” assets. During market panics, US bonds get
bid up. However, Indian assets are clubbed along with other “emerging
market” assets and sold-off. So, while having US bonds in a portfolio can
cushion it during sell-offs, owning Indian bonds may not offer the same
benefit.
Here’s how the US, Developed Markets and Emerging Market Bond funds have
behaved through time.
Bubble assets
Some assets, especially digital collectables, are prone to boom-and-bust
cycles. While Bitcoin gets all the press…

zerodha.com/varsity
372
373
… the fact that CryptoKitties raised a total of $23 million in venture capital
funding and people thought paying money to collect and breed virtual cats
on the blockchain was a good idea should give investors some pause.
A similar dynamic exists in the art market as well, where investors try to spot
emerging artists and bid up their works.
zerodha.com/varsity
373
374
28.4 – Keeping it simple
If you are starting, you will do well to stick with big, liquid asset classes:
1. Indian Equities
○ Large-cap Index
○ Mid-cap fund
2. US equities
Since large US companies have significant global footprints, the S&P
500 index gives ample exposure to most developed worlds. Indian
investors are unlikely to benefit much from chasing aer European,
Frontier or other Emerging markets.
3. Bonds
4. Gold
5. Real estate
If you are unsure of the relative proportions or you are just getting started,
then an equal weight allocation between them is not such a bad idea.
For US stocks, stick to the cheapest S&P 500 index fund that you can find.
For Bonds, find a short-term bond fund that invests only in government or
PSU bonds.
For Gold, go for the RBI issued Sovereign Gold Bonds that actually pays you
2.5% p.a. for owning gold.
For Real estate, see if exchange-traded REITs make sense.
28.5 -Risks to diversification
zerodha.com/varsity
374
375
As more assets get financialized, building a diversified portfolio becomes
easier and more accessible. But financialization also changes the behaviour
of the assets themselves.
Using real-estate as an example, transactions in the real-world take months
and involve a different set of actors than transactions on an exchange-traded
REIT that take seconds. The low historical correlations that one might have
seen between real-estate and stocks could’ve been a function of the different
venues where they were transacted, lower liquidity, long transaction times
and inability to cross-leverage. But once you put all these different assets on
the same platform and allow investors to lever one asset to buy another, you
end up increasing their correlations. So, while financialization makes it easier
to diversify, it blunts its effectiveness.
Keynotes from this chapter
● One cannot avoid buying assets.
● Know the different types of assets, and the factors drive their
returns.
● Draw-up an asset-allocation strategy (KISS: Keep It Simple,
Stupid!)
● Stick to the allocation strategy because prediction is
impossible.
● Nothing works all the time. The world around you changes. Be
pragmatic.
zerodha.com/varsity
375
376
CHAPTER 29
Exchange Traded Funds
Please note, this is a guest chapter, and I’ve not authored this. This chapter on
ETFs is authored by my colleague, Bhuvan. However, I’ll try and answer all the
following queries that you’d post. 
Happy learning, 
-Karthik Rangappa. 
29.1 – Overview
In chapter 7 , we looked at what a mutual fund is and how it works. To recap, a
mutual fund is a pooled investment vehicle that collects the money from
various investors, invests and manages that money on their behalf. When you
invest in a mutual fund before the order placement cut-off time, you will get
the units as per the same day’s NAV which is disclosed by midnight. If you
invest aer the order placement cut-off time, you’ll get the allotment of units
per the next day’s NAV. Basically, everything happens at the end of the day.
Now, what if those mutual funds units could be traded on the stock exchange
just like stocks like Reliance or Infosys? Just like a mutual fund, an
exchange-traded fund (ETF) is a pooled investment vehicle that holds a
basket of securities like stocks, bonds, and commodities and trades on the
stock exchanges. You can buy and sell an ETF anytime, just like a stock.
zerodha.com/varsity
376
377
There are a few more nuances to an ETF than a mutual fund, but before we
dive in, I hope you have a working idea of what an ETF is.
29.2 – History of ETFs
Mutual funds have been around in some form for well over 100-years. The
first open-ended mutual fund in the US was launched in 1924 and is still in
existence today. The first mutual fund in India was launched in 1964. Mutual
funds have democratized access to stocks, bonds, real estate and
commodities globally to common investors. Exchange-traded funds (ETF)
were the next evolution of mutual funds.
ETFs, on the other hand, are relatively new. The SPDR S&P 500 trust, arguably
the first ETF, was launched in 1993 in the US. Coincidentally, it is today the
largest traded security in the world. NiyBeES, an ETF tracking the Niy 50
index was the first ETF in India and was launched in 2000. It was launched by
Benchmark AMC, which Goldman Sachs later acquired, which Reliance later
acquired, which Nippon India Mutual Fund later acquired
🙂
29.3 – ETFs in India
Though ETFs have been around for a while in India, they haven’t really been
popular among retail investors. ETFs have mostly been used by HNIs and
institutions. For example, the SBI Niy 50 ETF with Rs 89,441.55 cr is the
largest mutual fund in India. This is almost entirely because this is one of the
ETFs in which the Employees’ Provident Fund Organisation (EPFO) invests.
A large part of the ETF AUM growth is due to:
zerodha.com/varsity
377
378
● EPFO investing in Niy & Sensex ETF
● Government divestment through CPSE ETF and Bharat 22 ETF
● Introduction and the Govt push for Bharat Bond Debt ETFs. Most of the
AUM in these ETFs is non-retail.
Growth of ETF AUM in India
Though still a small piece of the pie, retail participation has been growing
steadily over the years and so has the trading turnover on the exchanges.
NiyBeES which is 20 years old, just has about Rs 2800 crores of AUM. There
are a lot of reasons for the under penetration of ETFs:
1. India is still a tiny market. We just have about 1.7 crore active demat
accounts, and unlike a mutual fund, you can only buy an ETF if you
have a demat account.
2. Investment products, be it mutual funds or ETFs are push products.
One of the reasons why mutual funds are larger than ETFs is because
AMCs can pay distributors & platforms commissions to sell their mutual
funds. But ETFs don’t have commissions like mutual funds.
zerodha.com/varsity
378
379
3. ETFs are also relatively trickier to understand initially compared to
mutual funds. But we’ll take care of that with this chapter.
4. Most AMCs rarely push ETFs because they have low margins and don’t
make sense with small AUMs.
29.4 – What is an ETF?
An exchange-traded fund (ETF), just like a mutual fund is a basket of
securities, but this is where the similarity with a mutual fund ends. Unlike a
mutual fund, an ETF trades throughout the day on the stock exchanges. You
can buy and sell an ETF anytime you want just like a stock.
For example, if you search for “Niy ETF” on Kite, you’ll see a list of all ETFs
that track the Niy 50 index.
zerodha.com/varsity
379
380
Searching ETFs on Kite
29.5 – How does an ETF work?
When you buy a mutual fund, the AMC takes money from you and buys the
securities and discloses the NAV at the end of the day. Similarly, when you
redeem your mutual funds, the AMC sells the securities and returns your
money. This is quite straightforward. However, when you buy an ETF, you
don’t really interact with the AMC most of the time because most buying and
selling happens on the stock exchanges. It’s just an exchange of units
between buyers and sellers.
29.6 – Creation and redemption mechanism
I said when you buy an ETF, you “mostly” don’t interact with the AMC and I’ll
explain what that means. If you remember chapter 6 , we discussed all the
entities involved in an MF transaction — the AMC, custodian and the RTA. But
what makes an ETF unique is something called the creation and redemption
mechanism. But before we talk about it, you need to know a couple of things.
zerodha.com/varsity
380
381
1. NAV, iNAV, the market price
2. Market makers and authorized participants
3. Creation units
4. Premiums & discounts
5. Tracking error
Market price
When you buy a mutual fund, you look at the NAV. Similarly, when you are
buying an ETF, you look at the ETF market price on Kite.
ETF prices
These prices are determined by the demand, supply and the trading activity
on the exchanges. But how do you know if the price you see on Kite is the fair
price you are paying for an ETF? Here’s where the Net Asset Value (NAV)
comes in.
Net asset value (NAV)
zerodha.com/varsity
381
382
Like a mutual fund, an ETF also has an end of the day Net Asset Value (NAV).
Just to refresh your memory, NAV tells you the total value of all the fund’s
assets and yours. The formula for calculating NAV is NAV = (Value of all the
assets – the expenses)/number of shares (units). But remember, an ETF
trades real-time, whereas NAVs are only announced at the end of the day. So
how do you figure out if the price you are paying for an ETF is fair in real-time?
Enter iNAV
Intraday or indicative net asset value (iNAV)
Given that ETFs trade real-time, you need a reference point to see if the
market price you see on your trading platform is a fair one and the indicative
or intraday NAV (iNAV) serves as that reference. AMCs usually calculate this
every 10-15 seconds and publish it on their websites. iNAV = last traded price
of all the securities in the ETF basket X number of shares in the ETF creation
basket + cash component (i.e. cash which is not deployed in the ETF) divided
by total ETF shares in the creation basket. Put simply; this serves as a
real-time NAV so that you can use this as a fair value reference to compare it
with the current market price on the stock exchanges.
Creation unit
Like buying ETF units on the stock exchange, you can also buy units directly
from the AMC. I’ll explain why you’d want to do that later. But, unlike the
exchanges, you cannot buy 1 or 2 units directly from the AMC. You can only
create and redeem units in what’s called the creation size that the AMC
defines. A creation unit is nothing but a representative basket of all the
securities in the same proportion as the underlying index. For example, the
zerodha.com/varsity
382
383
creation unit size of the ICICI Niy 50 ETF is 50,000 units, and as of this
writing, it’s about Rs 80 lakhs. Meaning, you need 80 lakhs to buy all the
stocks in Niy 50 in the same weight.
Market makers and authorized participants (APs) 
Unlike mutual funds, there’s another entity called market markers or
authorized participants in the ETF ecosystem. The role of these guys is to
provide liquidity on the stock exchanges. You don’t have to worry about
liquidity in a mutual fund because there’s no real-time trading. But since an
ETF trades real-time on the exchange, market makers are appointed by the
AMC to provide liquidity continuously. They do this by providing continuous
two-way quotes on the exchange, meaning they buy at the bid and sell at the
offer , and the difference is the profit they make. Even though these are small
amounts, since they keep doing this, it tends to add up.
Market makers typically tend to be large brokers in India.
Premiums and discounts
Since an ETF trades real-time on the exchanges, their price is influenced by
demand and supply—the prices of liquid ETFs trade in line with the NAV of the
ETF most of the time. But sometimes, particularly during volatile market
phases, the price of an ETF can trade away from the NAV of the ETF. If the
price of an ETF is above its NAV, it’s called a premium and if the price is below
it’s NAV, it’s called a discount.
Tracking error
zerodha.com/varsity
383
384
Tracking error is the annualized standard deviation of the difference between
the ETF NAV returns and the index that it tracks. In simple terms, it shows you
how closely an ETF tracks its underlying benchmark. A simple example would
be if Niy 50 returned 10% and Niy ETF gave 9.8%, the tracking error would
be 0.2%. An ETF or an index fund will have lower returns than the index
because they have an expense ratio and an index doesn’t.
A lower tracking error indicates that an ETF or an index fund is tracking the
index better. But this is not really an intuitive measure to understand and
we’ll discuss that later.
With these concepts in mind, let’s get back to the concept of creation and
redemption mechanism
There are a few reasons why the creation and redemption mechanism is
important. For one, you need not always buy an ETF on the stock exchange. If
you are buying in multiples of the creation unit size, buying it directly from
the AMC is way better because you might face liquidity issues and impact
costs when you buy large quantities on the exchange.
So, in the example I mentioned above, the ICICI Niy 50 ETF’s creation size is
roughly 80 lakhs. If you are investing in multiples of 80 lakhs, you can directly
contact ICICI, and they will create units, in this case, 50,000 units and credit
them to your demat. The AMC will create units at the iNAV. Similarly, you can
redeem them by transferring the ETF units to ICICI, and they will credit the
cash to your bank account or you can also get the underlying shares instead
of cash.
zerodha.com/varsity
384
385
The second reason why creation and redemption mechanisms are important
is for ETF arbitrage. Like I mentioned earlier, ETFs can trade at premiums and
discounts to the NAV. Market makers are essential in the ETF ecosystem
because they are responsible for correcting these premiums and discounts.
They do this through the creation and redemption mechanism.
Typically ETFs trade close to their NAVs. Here’s a comparison of Niy BeEs,
SBI Niy ETF, ICICI ETF and Niy 50.
Niy ETFs vs Niy 50
But during a volatile market phase, for example, like the COVID crash in 2020,
there can be wide premiums and discounts. Here’s how even a popular ETF
like NiyBeEs and SBI Niy 50 ETF, India’s largest mutual fund performed
during the volatile market phase of March-April 2020.
zerodha.com/varsity
385
386
Nifybees vs Niy 50
Now, here’s where the market makers come in. If there’s a premium, the
authorized participant (AP) will buy all the underlying securities that make up
the ETF creation unit. In this case, the AP will buy all the 50 Niy stocks of the
same weight; this is also called the creation basket and give them to the AMC.
In turn, the AMC will create ETF shares and give them to the AP, who will then
sell them on the exchange.
Similarly, if there’s a discount, the AP will buy the ETF units on the exchange
and give them to the AMC. In return, the AMC will give the underlying shares
of the ETF to the AP, who will, in turn, sell them in the market. The difference
between the premium, discount, and the NAV will be the AP/market maker’s
profit.
Perhaps, the best example of this would be the Motilal Oswal NASDAQ 100
(N100). During 2017-2018, the ETF was trading at a huge premium to the NAV.
The premiums were as high as 20%+. This was probably because the market
makers weren’t active in providing liquidity. Value Research allows you to
zerodha.com/varsity
386
387
compare the NAV and price , here’s a chart, notice the huge difference
between the NAV and the price.
Someone could have taken advantage of this premium by going to Motilal
AMC and asking them to create units, which happens at the NAV and sell them
at the market price on the exchange. The difference would’ve been the profit.
N100 ETF price vs NAV
This premium persisted for a long time. Then Motilal, If I’m not wrong,
appointed new market makers and launched a fund of funds (FOF) for the
ETF, which corrected the premium. So the market maker around 2018 would
have created Motilal units at the NAV and sold them on the exchange at the
market price and corrected the premium.
zerodha.com/varsity
387
388
N100 ETF price vs NAV
This is how the creation and redemption mechanism in an ETF is used to
ensure liquidity and arbitrage premiums and discounts.
29.7 – ETF liquidity
This is the most important thing when buying or selling an ETF because they
trade real-time. When choosing an ETF, most people tend to look at the AUM
of an ETF and the trading volumes to decide if an ETF is liquid. Although these
2 things should be considered, the size of an ETF or the daily trading volumes
alone don’t indicate liquidity.
Let’s unpack what ETF liquidity really means. It’s essential to remember at
this point that even though ETFs trade like stocks, they are not the same.
zerodha.com/varsity
388
389
Layers of ETF liquidity -American Century

Secondary market liquidity: This is what you see on your trading platform.
The spread between the bids and offers give you an idea of the available
liquidity, but that’s not all. Take a look at this image, comparing Mirae Niy 50
ETF and LIC Niy 50 ETF. The LIC ETF has an AUM of Rs 618 crs, and the Mirae
ETF has about 483 crs. As of writing this post, both the ETFs had just traded
500+ units.
zerodha.com/varsity
389
390
Spreads
Typically, you’d ignore both ETFs assuming that they are too small and don’t
trade much. But that would be an incorrect assumption because on-screen
liquidity isn’t everything.
ETF market depth: If you look at the Mirae ETF, nearly 60,000 shares are
available for purchase. That means, even if you place a market order, which is
a really terrible mistake when buying an ETF, you will get a good fill at Rs
157.44. This is probably a market maker posting a bid and an offer. The LIC
ETF, on the other hand, has no liquidity at all. If you’d have placed a market
order for 100 units by chance, your average price would have been way higher
than the last traded price, given that there are no volumes and your order
would’ve been continuously executed at higher and higher prices.
So, AUM and trading volumes don’t tell you everything. Market markers
typically hold units that don’t show up in the market depth. If you place a
limit order to buy, your order will be executed as the market makers place an
zerodha.com/varsity
390
391
order to sell. But yeah, not all ETFs have active market makers, this has to be
part of your ETF due diligence which we’ll talk about in a bit.
Here’s how the Mirae ETF and LIC ETF have tracked Niy 50. While Mirae has
closely tracked Niy 50, LIC has been all over the place trading at premiums
and discounts.
Mirae vs LIC Niy 50 ETF
Primary market: The third layer of ETF liquidity is the primary liquidity.
Remember, a stock has a fixed number of shares on offer, But even though an
ETF trades like a stock, it’s not a stock. Market makers and investors can
create new ETF units. Large institutions, HNIs, typically don’t buy ETFs on the
exchange. They directly reach out to the AMC and create units that don’t
show up on your trading platforms’ market depth.
Liquidity of the underlying stocks: The last and the most important layer of
ETF liquidity is how liquid the underlying stocks that make up an ETF are.
Remember, an ETF is just a wrapper that holds all the stocks that make up the
ETF or an index. So, an ETF can only be as liquid as the underlying stocks.
zerodha.com/varsity
391
392
This might be a little confusing, so let’s take an example. Today, in India, we
don’t yet have a small-cap ETF, have you ever wondered why? In the Indian
markets, the liquidity quickly starts disappearing aer the 200 largest stocks.
As we go down the market cap, the smaller stocks tend to have less
outstanding shares, less trading volumes, and usually keep hitting upper and
lower circuits.
So, assuming there was a small-cap ETF and that there was a sudden spike in
demand, the market maker would have had to create units to satisfy the
demand. Now if some of the underlying stocks are not liquid or have hit
circuits, which is quite common in small-caps, he wouldn’t have been able to
create units. In such a case, the ETF will probably trade at a premium to the
NAV because there will be more demand for the existing units. Not just,
small-caps, even mid-cap stocks in India have liquidity issues. So, an ETF can
only be as liquid as it’s underlying stocks. But this isn’t a problem in a
large-cap ETF like a Niy 50 ETF because these are the biggest and the most
liquid stocks.
To summarize, trading volumes and AUM are factors, but they don’t tell you
everything about an ETF.
29.8 – ETF choices in India
Like I mentioned at the start of the chapter, ETFs are pretty new in India, we
have about 88 ETFs today. A majority of them are equity ETFs. Here are your
ETF choices:
1. Equity ETFs
There broadly 2 sub-categories of equity ETFs. You have your plain
zerodha.com/varsity
392
393
vanilla market-cap-weighted ETFs that track indices like the Niy 50,
Niy 100, Sensex etc. And then you have smart beta ETFs which target
factors such as value, quality, low-volatility, momentum etc.
2. Debt ETFs
We have debt G-sec ETFs, Bharat bond ETF which just holds bonds
issued by PSUs, and then you have an ETF like the CPSE+SDL ETF by
Nippon which holds PSU bonds and State development loans (SDLs).
3. Commodity ETFs
For now, we just have gold ETFs.
Here’s a list of all Indian ETFs .
Are all ETFs passive?
This is a common question that keeps coming up. Today, the biggest ETFs we
have are passive ETFs that track either the Niy 50 or Sensex 30. But smart
beta ETFs aren’t passive, even though the ETFs track an index. They are more
of a hybrid of active & passive like we discussed in the smart beta chapter .
Globally, 80-90% of all ETFs are passive, but we see the first traditional active
ETFs in the US. Maybe, we’ll eventually see them in India as well. So ETFs
need not be all passive, it’s just that they are passive today.
ETF due diligence
I know this has been a little long, but the idea was to give you the full context
you need before investing in an ETF and help you avoid rude surprises. And I
hope at this point; you have a clear understanding of how an ETF works and
zerodha.com/varsity
393
394
its mechanics. With that in mind, let’s now look at some things you should
consider before you buy an ETF.
Always use limit orders
I cannot stress this enough but never use market orders when buying an ETF,
always use limit orders. This is one mistake I see investors constantly make.
We saw this earlier but let me reiterate this with an example. Take a look at
the market depth of Aditya Birla Sun Life Niy Next 50 ETF. If you placed a
market order for 200 units, your order would be executed at prices starting
from Rs 350, which is above the LTP, to begin with, and finally, at Rs 374, that’s
8.7% higher than the LTP. So, always use limit orders.
Market depth of Aditya Birla Niy Next 50 ETF
zerodha.com/varsity
394
395
Always check the iNAV
Always look at the iNAV on the AMC website and place a limit order at that
level. Don’t just place a limit order without looking at the iNAV. The other
issue is that sometimes AMC websites don’t update their iNAVs or their
websites might be down. If there is a big difference between the last updated
iNAV and the current market price, that’s a sign that there is something
wrong. So, make sure to compare the ETF with the intraday chart of the
underlying index of the ETF on Kite, and that will give you an indication if the
price is correct. Check with the AMC in such a case before placing an order.
Compare the NAV and the price of an ETF and see how it has performed
You should always buy an ETF that tracks the underlying index as closely as
possible. Here’s how Nippon NiyBeEs ETF has tracked it’s NAV, it’s pretty
close. You can compare the price and the NAV on Value Research ; we’ll try
having this feature on Coin.
Niybees NAV vs price
zerodha.com/varsity
395
396
Picking up on the earlier point about the tracking error, AMCs disclose the
tracking error on their factsheets. But if you see a tracking error as 0.02%, it’s
hard to understand what it means. Moreover, AMCs calculate the tracking
error on the NAV, but you buy and sell based on the price, which can be totally
different. So the best way to analyse an ETF is to look at the difference
between ETF prices and the underlying index. You want the price of ETF to
track the index consistently without huge differences.
Note: Always compare the ETF price with the total returns index (TRI) and
not the price returns the index (PRI). The TRI includes dividends. All the
index data you see on Kite is PRI. Since ETFs track TRI indices, they
reinvest the dividends which reflects in the NAV of the ETF. 
Look at the average volumes
Look at the average volumes over a period of time and see how an ETF has
traded. You should invest in an ETF that trades regularly. You should avoid
ETFs that just have a brief spike in volumes and then don’t trade. The
Edelweiss ETF – Niy 100 Quality 30 is an example. The monthly average
volumes are about 150 units. You can check the average volumes by applying
a moving average on the volume chart on Kite. So assuming you had bought
this ETF and had to exit, you most likely wouldn’t have been able to.
zerodha.com/varsity
396
397
Edelweiss ETF – Niy 100 Quality 30
Avoid buying and selling at market open
Most ETFs don’t trade much for 30 mins to 1 hour of the market open. They
also tend to trade at abnormal prices because of the low volumes, even
orders for a few units can move prices. If you can, avoid trading in the open.
And if you have to, check and verify the iNAV and use limit orders.
Is the AMC focussed on ETFs?
Today, most of the AMCs offer ETFs but that doesn't mean they are serious
about them. Most of the ETF volumes are in ETFs offered by Nippon, ICICI,
and SBI largely. Other AMCs like Mirae, Edelweiss with their debt ETFs do
seem serious about building out their ETF offerings. So, along with the other
things on the due diligence list, you’ll also have to look at whether an AMC is
serious about the ETFs it offers. For example, if you look at some of the ETFs
by Aditya Birla Mutual Fund, IDBI, LIC, Indiabulls etc., they have horrible
tracking errors and almost no volumes.
zerodha.com/varsity
397
398
Creating units with the AMC for higher-value investments
If your investments in ETFs are equal to or more than the creation basket
value, it’s better if you approach the AMC to create units rather then buying
on the stock exchange.
29.9 – ETF vs index funds
This is another question that keeps coming up. Hopefully, this table should
help answer these questions. In short, if you want to have active control or if
you are actively using passive ETFs, then ETFs are a better choice. But if you
are lazy like me and want to make as few choices as possible, then index
funds are a better choice.
With ETFs, you can express tactical strategies better than index funds because
you can’t buy and sell index funds immediately.
zerodha.com/varsity
398
Index funds
Exchange-traded funds
End of the day NAV
Real-time pricing. Can be bought
and sold anytime
399
zerodha.com/varsity
399
No issue of spreads because
execution happens at the end of the
day
You might see wide spreads in
certain ETFs and during market
volatility.
Liquidity isn’t an issue and can be
managed.
Certain ETFs don’t trade much, and
underlying liquidity of stocks can
impact APs and market-making
Can create SIPs
Possible with Zerodha, may not be
possible with other brokers
Expense ratio is all-inclusive—no
additional charges
You have to pay a brokerage (free at
Zerodha) & other charges & taxes
separately
Not possible to have tactical
strategies. Less flexible compared to
ETFs
With ETFs since you can buy & sell
anytime, you can express tactical
views. ETFs are much more flexible
400
29.10 – Performance of ETFs vs actively managed funds
We discussed this earlier in the index funds chapter as well. In the last decade
or so, index funds and ETFs have become increasingly popular around the
world. One reason is that investors have increasingly realized that a vast
majority of actively managed mutual funds don’t beat their benchmarks. In a
developed market like the US, ~90% of active funds don’t beat their
benchmarks.
The Indian markets have grown a fair bit and have become increasingly
professionalized; institutional investors are a big part of today’s market. This
means that most of the informational edges and asymmetries have been
arbitraged away. Today, pretty much everyone has access to the same
information. The odds of someone finding some piece of information that can
move a stock, at least in the large-cap space, for example, is pretty much zero.
zerodha.com/varsity
400
Index funds tend to hold more cash
and hence have a slightly higher
tracking error
ETFs don’t hold much cash and
hence have a lower tracking error
Lesser choice at-least as of now. But
AMCs are launching a fund of funds
for ETFs
Pretty much all of the smart-beta
products are ETFs. You have a wider
choice
401
But perhaps the biggest reason why active funds underperform is that they
charge too much.
Actively managed large-cap funds on an average charge~1.5% whereas a Niy
50 index fund is available for 0.10%. And we see this in the performance. S&P
publishes a report called SPIVA , which measures the performance of active
funds. For any period, over 70% of all large-cap funds fail to beat their
benchmarks.
SPIVA India
Traditionally, the view was that the mid-cap and small-cap space was
inefficient, and this was where stock pickers thrived. While this was true, it
seems like this is increasingly becoming less so. In the last 5 years since the
SEBI categorization exercise, active mid-cap funds have had a tough time
keeping up with a broad mid-cap benchmark like the Niy 50 or BSE/NSE
Mid-cap 150 index and even Niy Next 50 etc. Here’s a quick look, this is just
for illustration, and ideally, you should look at the rolling returns .
zerodha.com/varsity
401

3 Yr Ret (%)
5 Yr Ret (%)
10 Yr Ret
(%)
402
zerodha.com/varsity
402
Fund Name
Kotak Emerging Equity Fund
Regular Plan
12.09
19.16
17.89
DSP Midcap Fund – Regular Plan
10.97
18.49
16.63
Invesco India Mid Cap Fund
13.24
18.07
17.95
Edelweiss Mid Cap Fund –
Regular Plan
9.85
17.92
18.28
Nippon India Growth Fund
10.68
17.65
13.27
BSE Midcap 150 Index
9.07
17.6
12.94
403
zerodha.com/varsity
403
Taurus Discovery (Midcap) Fund
– Regular Plan
9.44
17.59
15.3
Tata Midcap Growth Fund –
Regular Plan
11.2
16.91
16.93
HDFC Mid-Cap Opportunities
Fund
8.03
16.44
17.41
L&T Midcap Fund
5.39
16.33
16.15
Franklin India Prima Fund
8.86
15.79
17.27
ICICI Prudential Midcap Fund
6.98
15.28
15.07
UTI Mid Cap Fund – Regular Plan
8.68
15.27
17.2
404
zerodha.com/varsity
404
BNP Paribas Midcap Fund
8.44
14.94
17.59
Baroda Midcap Fund
8.52
14.51
3.73
Motilal Oswal Midcap 100
Exchange Traded Fund
5.8
14.36
12.11
SBI Magnum Midcap Fund
9.36
13.97
17.37
Sundaram Mid Cap Fund –
Regular Plan
3.56
13.25
14.98
Quant Mid Cap Fund
12.15
13.01
11.29
Aditya Birla Sun Life Mid Cap
Fund
2.77
12.28
12.94
405
The bottom line is that most actively managed funds don’t outperform a
simple broad-market ETFs or index funds like Niy 50, Niy Next 50 and Niy
Midcap 150. This is due to a combination of high costs, increasing market
efficiency, and internal fund mandates to not deviate too much from the
indices. Moreover, it’s tough to pick those funds & managers that beat their
benchmarks. And even if you figure out how to pick a winning manager, there
is very little persistence in performance. The best performing fund oen ends
up being the worst-performing fund over a period of time.
Today, it’s a no-brainer to look at index funds in the large-cap space. There’s
increasing evidence that it’s the same in the mid-cap space as well. As for
small-caps, these are severely risky and buy and hold may not be an optimal
strategy, and active management both in a fund and in timing is needed.
Key takeaways from this chapter
● ETFs trade real-time on the stock exchanges and you can now
set-up SIPs in ETFs to invest every month
● Blindly choosing an ETF is a bad idea. ETF due diligence before
investing is extremely important
● ETF liquidity is an issue in India because our are markets are
still small and this needs to be kept in mind when buying and
selling
● Always use limit orders and compare the market price of the
ETF with the intraday or indicative NAV (iNAV) before buying
and selling
zerodha.com/varsity
405
406
● You can check the iNAV on the respective AMC’s website
● Sometimes the iNAVs on AMC sites may be wrong. If the
difference between iNAV and the price is huge, it’s a red flag.
● Compare the ETF price with the underlying index or check
with the AMC in cases where the ETF prices are way off from
the iNAVs/NAVs
● Large-cap and mid-cap Index ETFs make a lot of sense vs
actively managed large-cap and mid-cap index funds
zerodha.com/varsity
406
407
CHAPTER 30
Basics of Macro Economics
30.1 – Why macroeconomics?
The module on Personal Finance has come a long way with over 30 chapters. I
can easily think of another 10 or 15 chapters to add, but I won’t do that
🙂
I think we have covered the major chunk of personal finance, i.e. investments
(via mutual funds), and in the process, discussed a ton of other information. I
hope you’ve found this module useful.
I want to end this module with a chapter on MacroEconomics.
Macroeconomics in a personal finance module? Well, I’m sure you may
wonder why I’d want to discuss macroeconomics in a personal finance
module. Aer all, personal finance is related to an individual or a family’s
finances. On the other hand, macroeconomics is a much wider topic related
to a country’s economic well-fare.
What is the connection here?
You like it or not; your financial fortune is highly dependent on how the
country as a whole does; this is especially true when you save for long and
hyper long-term investment goals like retirement.
Imagine this; you set retirement as your financial goal. As a part of this, you
do your bit diligently, i.e. select your mutual funds carefully, save regularly,
zerodha.com/varsity
407
408
increment your savings by the year, and stick to the course and not succumb
to the temptation of pulling out the funds during the tenure.
However, the country you reside in happens to default on its borrowings and
suffers from never-ending geopolitical and civil unrest.
Given the situation, do you think your savings will do well?
Or think about a situation in your country at the cusp of a big bang economic
reform, with an extremely supportive demographic profile and a
super-competent Government. But you fail to see through these shining
opportunities and instead decide to play safe and invest your hard-earned
money in gold.
Do you think you’d have taken the right investment decision here?
Hence, for this reason, I think it is very important for an individual to
understand the basic macroeconomic profile of the country and map it to the
past macroeconomic profile and extrapolate a bit to the future and see how
the situation pans out.
In this chapter, I’ll stick to basics and help you understand the absolute
essential macroeconomic principles. If the topic interests you’d, I’d suggest
you pick up any good undergraduate book on macroeconomics and read
through it. I’m sure you won’t regret it
🙂

zerodha.com/varsity
408
409
30.2 – Gross Domestic Product (GDP)
I understand this is an absolute basic metric to start our discussion, but we
will start with it for the same reason. Many of you may be familiar with it; if
yes, please feel free to skip this section. For those who are not familiar with
‘GDP’, let me tell you a quick story.
Aer my sister’s marriage in 2002, she moved to Coimbatore, Tamil Nadu. I
was in my early 20’s, and I’d oen make weekend trips to Coimbatore to visit
her and spend a few days with her. My sister had a very interesting neighbour
in Coimbatore, and she would oen tell me stories about them. On one of my
visits, I got to meet the neighbours as well.
The neighbour’s house had three family members – husband and wife, both
in their mid 50’s and a teenage daughter. Husband managed a steel
kitchenware shop, which sold household items like rice cooker, pots, and
pans. His wife managed a small homemade papad and pickle business, and
the teenage daughter taught classical dance to the neighbourhood kids.
All three members of the house had an economic output. Given my
unnecessary curiosity, I remember trying to figure out how much money this
family made. I don’t remember the exact math, but I remember these
numbers; I estimated that –
○ The husband sold goods worth 2 to 2.5L lakhs per month.
○ The wife sold goods worth 25K every month.
○ The daughter charged 500 per month per kid and had ten
students, which was 5K per month.
zerodha.com/varsity
409
410
Give or take, this small and admirable family’s monthly income was anywhere
between 2.3 to 2.8L per month or about 34L per year on a gross basis. This
family had no other source of income. In other words, 34L was the total
economic output of this family aer accounting for all the products and
services collectively sold by this family.
In a sense, I think it is ok to conclude that the family’s Gross Domestic
Product' (GDP) was 34L per year. If you realized, GDP here represents the
total value of the economic output of the family, which includes goods sold
(kitchenware), products manufactured and sold (papad and pickle), and
services offered (dance classes).
Now step aside and think about the country as a whole. The country has
many factories, companies, services units of various kinds; all of these
collectively have an economic output. The combined economic value of all
these entities (operating within the geographic boundaries of the country)
zerodha.com/varsity
410
411
represents the GDP of the country. If the companies do well and thrive, then
naturally, the GDP of the country increases.
Or in other words, a growing GDP is a healthy economic sign. We all want the
GDP of the country to increase.
Have a look at the Indian GDP ranking –
I’ve got this from Wikipedia, where they have tabulated the 2020 GDP rank of
countries as per various estimates (IMF, World Bank, and UN).
India ranks around 6th or 5th, and the GDP itself is pegged to 2.6 to 2.9
Trillion USD. Do recollect, the collective economic output of India is
estimated between 2.6 – 2.9 Trillion USD. We are just below China, Japan, UK,
and Germany.
While it is great to know we are in the top 5 GDPs of the world, it is also
important to understand how our GDP grows. Aer all, we want to be better
than being in the top 5, and we want to get there as quickly as possible.
To measure the speed at which a country’s GDP is growing, we need a growth
rate. The number is usually expressed in percentage terms. Hence, if the
percentage is 5%, it implies that a country’s GDP grows at 5%.
zerodha.com/varsity
411
412
The technique of estimating the GDP growth rate is beyond this discussion’s
scope; we won’t get into that today but will use the widely accepted number.
Now, when it comes to measuring the GDP growth, there are two terms you
should familiarize yourself with –
○ The nominal GDP growth rate
○ The real GDP growth rate
Both these growth rates measure the speed at which the GDP grows; if you
guessed right, these rates are the CAGR of the GDP. Do recollect; we have
discussed CAGR several times in this module.
To put this in context, take a look at this new paper headlines –

The reference point here is the ‘nominal growth’ rate.
The nominal growth rate is the absolute growth rate. While it is ok to use the
nominal growth rate, it may not be an accurate representation of ground
realities.
Let me explain.
zerodha.com/varsity
412
413
Think of it as investing Rs.100 in stock. At a 10% growth rate and five years,
Rs.100 grows to Rs.161/-. But is the value of Rs.161/- in 5 years the same as
Rs.161/- today? Won’t it be right? And we know it won’t be the same because
inflation eats into the purchasing power of money on year on year basis.
Hence to get the most accurate representation, we need to adjust the growth
rate to inflation. When we adjust the nominal GDP growth rate to inflation in
GDP, we get the real GDP growth rate.
Real GDP growth = Nominal GDP growth – Inflation.
Assuming the inflation at around 4.5% (ranges between 4.5% to 5%), real GDP
of India –
10% – 4.5%
= 5.5%
Do take a look at this snapshot; it estimates the real GDP growth at 5% –
The snapshot is from the Department of Economic Affairs; you can read the
entire paper here – https://dea.gov.in/sites/default/files/March%202020.pdf .
I also found this interesting chart from the same paper; I thought I’d share it
here for your quick reference –
zerodha.com/varsity
413
414
Thanks to COVID, most of the economies (from the GDP perspective) took a
hit in 2020. But they are all expected to bounce back up in 2021 and perhaps
2022. Whether this will pan out as per estimates or not is an unknown. But the
stock markets at least seem to factor this
🙂
Anyway, at this point, I want you to take a break and think about this –
○ You understood what GDP is
○ You understood the GDP growth rate, both nominal and real.
How is this relevant to personal finance?
30.3 – GDP and Market cap
We have discussed the concept of market cap earlier in Varsity. For those of
you not familiar with market cap, here is a quick note –
zerodha.com/varsity
414
415
Assume the stock price of a certain company is Rs.75/- per share. Further,
assume that the company has only 1000 shares outstanding of this company.
The market cap of this company is –
Stock price x total outstanding shares
= 75 x 1000
= Rs.75,000/-
The total outstanding shares of this company are constant, but the stock price
fluctuates daily. The higher the stock price, the higher is the market cap and
vice versa.
Now assume another company has 2000 shares outstanding, and the stock
price is 105 per share. The market cap of this company is –
= 105 x 2000
=2,10,000/-
Now assume (the last assumption, I promise) that the entire market
comprises just these two companies. The entire market cap of this market is –
75000 + 210000
=2,85,000/-
Hopefully, with this arbitrary example, you got a sense of the concept of
‘market cap of the market’. The market cap of Indian companies (sum of the
market cap of all the listed companies in the country) as of Jan 2021 is
roughly $2.5 Trillion.
zerodha.com/varsity
415
416
One of the direct established correlations is that as the country’s GDP
improves, so will the market cap. If the market cap does well, then equity
investments are bound to well. We have seen this happen in the past.
So when you look at the GDP data, think about how the country is placed in
terms of GDP, and it is expected to do over the next 5 or 10 years.
For instance, here is a thought about the Indian GDP situation –
○ India is a 2.6 Trillion USD GDP as of 2021
○ The real GDP growth rate is 5.5%
○ The countries above us in the GDP rank, i.e. Japan, Germany, and
the UK, have large GDPs, but their real growth rates are lower.
Even if India did nothing spectacular or did nothing stupid to degrow, then
under a decent real GDP growth rate (and slow down in developed countries),
the GDP rank is bound to increase.
zerodha.com/varsity
416
417
No think about a growing GDP plus the largest democracy globally, and top it
up with a large working population; what do you expect?
Well, these are factors that usually are a precursor to attracting more
investment capital into the country. With these investments coming in,
corporates are expected to do well, and in turn, the country’s market cap is
expected to do well.
Will this happen overnight? No.
Will this happen over the next 1-2 years? Maybe not.
Will this happen over the next 8-10 years? Well, it seems likely.
Hence, the need to stay invested for a longer-term.
30.4 – India Inc
Think about a corporate entity. A corporate entity or a company usually has
few sources of revenue and a set of expenses. The difference between the
revenue and expense, if positive, results in a profit to the company. If the
difference between the revenue and expense is negative, then that is a loss to
the company.
Now think about India as a company. The company’s management is the
Government, which is democratically elected. The company has a few
revenue sources, mainly in terms of taxes, and the company also has
expenses mainly in terms of capital and revenue expenses. If the income
minus expense is positive, that’s a surplus to the country, else a deficit.
zerodha.com/varsity
417
418
Take a look at the snapshot below; I’ve got this from the website of Controller
General of Accounts; here is the link –
http://www.cga.nic.in/GlanceReport/Published/2018-2019.aspx
The data you see above is for the Financial Year 2018-19, represented in
Rupee Crores. Let us break this down to understand the numbers better.
The first line here details India Inc’s Revenue; it is called the ‘Revenue
Receipts’. These receipts act as the sources of revenue for the Government.
There are two broad categories of revenue for the Government, i.e. Taxes and
Non-tax revenue.
Taxes Revenue – Tax revenue includes all sorts of taxes that the Government
collects. Broadly, taxes can be classified as ‘Direct Taxes’ and ‘Indirect Taxes’.
zerodha.com/varsity
418
419
The direct taxes include taxes paid by individuals, called the ‘Personal Income
taxes’ and the corporates’ taxes, called the ‘Corporate Income tax’.
Indirect taxes mainly include the tax in the form of ‘GST’.
As you can see, India Inc collected close to 14.8L Crore as taxes in 2018-19;
this includes both direct and indirect taxes.
Remember, when GST is charged, a portion goes to the state and a portion to
the centre. Hence when you look at 14.8LCr, this is the ‘net to the centre’,
which means that the actual tax collection is higher than 14.8L Cr. Of course,
you can get the exact value by inspecting this report further, but I’ll refrain
from doing so. But if I remember right, roughly 2/3rd is retained by the centre,
1/3 is distributed to states.
Non-tax revenue – Apart from the tax revenue, the Government has a ‘non-tax
revenue’ as an income source. The non-tax revenue source mainly includes
the dividends paid out by the PSU companies (companies like LIC, NTPCL,
ONGC, NALCO etc.), where the Government of India is a majority stakeholder.
Apart from dividend income, the Government also has revenue by selling
stakes in these companies, oen referred to as the disinvestment program.
The non-tax revenue for 2018-19 was roughly 2.4L Cr.
Total revenue is the sum of these two revenue lines, which is roughly 18.2L Cr.
The Government has expenses, and these expenses can be categorized into
two buckets, i.e. the ‘Revenue Expenditure’ and ‘Capital Expenditure.
Revenue Expenditure – These expenditures include subsidies across various
Government schemes, salaries to Govt employees, interest payments etc. The
zerodha.com/varsity
419
420
revenue expenditure is a big bill that the Govt has to pay, and as we can see
from the snapshot, this bill stood at 21.4L.
Capital Expenditure – The capital expenditure, on the other hand, is the
Government’s expenditure on infrastructure; this includes things like roads,
bridges, hospitals, electrical grids, transportation etc. The capital expenditure
is 3.1L Crore.
Think about it, capital expenditure is 3.1L Cr, while the revenue expenditure is
nearly seven times more at 21L Cr. If the Govt were to spend more on Capital
expenditure, it leads to better infrastructure, spurs business growth, creates
jobs, and leads to better tax collection.
As a long-term investor, you need to keep track of trends in these spend
patterns and get a sense of how the country is evolving.
The sum of revenue and capital expenditure is the total expenditure of the
Govt, which is roughly 24.57Cr.
So, on the one hand, Govt collected revenue of 18.2L Cr, and on the other
hand, the expenses stood at 24.57Cr. The expenses are much higher than the
income. The negative difference, i.e. to the extent of nearly 6.3L Cr, is called
the ‘Fiscal Deficit’.
From the same report, I’ve pulled the GDP data –
zerodha.com/varsity
420
421
The country’s GDP as per 2018-19 data is 190.1L Crore. If you calculate the
Fiscal Deficit as a percentage of GDP –
6.3L Cr / 190.1L Cr
= 3.3%
Any macroeconomic debate or discussion, this is the ratio that gets spoken
about the most. The Government puts in massive efforts to contain the Fiscal
Deficit to GDP ratio to sub 4%.
To put this in perspective, do check this extract from Wikipedia –
The US’s fiscal deficit as a percentage of GDP is nearly 4.7%, which is quite
staggering.
zerodha.com/varsity
421
422
While at it, we can crunch one more data point, i.e. net tax collected as a
percentage of GDP –
= 17.3/190.1
= 9.1%
If we include the share of state’s, this ratio is roughly at 11-12%. Tax collection
as a percentage of GDP is an important metric; remember, the higher the tax
collection, the higher is the revenue, which means the probability of
shrinking the fiscal deficit is higher.
So what will lead to higher tax collection? Things like newer job creation,
business expansion, improvement in ease of doing business, greater
compliance, etc., result in higher tax collection.
Again, to remind you, you need to track these numbers to understand how
the country operates. Remember, when you invest in the long term, your
fortunes depend on how your investments perform, depending on how India
as a country performs.
Without a sense of these basic details, it is equivalent to investing in the dark.
I’ll end this discussion here; as you can imagine, the topic is vast, and we have
only scratched the surface
🙂
With this, we are at the end of this module on the Personal Finance module; I
hope you’d enjoyed reading this, as much I enjoyed writing this for you.
Good luck and invest wisely
🙂
zerodha.com/varsity
422
423
Key takeaways from this chapter
● The country’s GDP represents the country’s collective
economic output; this includes all the goods and services
produced within the country’s geographic boundary.
● The nominal GDP growth rate is the GDP’s absolute growth
rate; it does not adjust for inflation.
● The real GDP growth rate adjusts for inflation.
● With 2.6 to 2.9 Trillion USD, India’s GDP stands at
5th/6thposition in the global GDP rank.
● As the GDP of the country expands, the market cap also tends
to expand.
● India Inc’s revenue consists of tax and non-tax revenue.
● India, Inc’s expense consists of revenue and capital
expenditure.
zerodha.com/varsity
423